Apple's (AAPL) 2012 rapid price rise has produced the risk of a significant price drop. The problem is that the uptrend is being seen as confirmation of Apple's superiority, so concern has diminished just when caution is warranted. Instead, there is building confidence that the fast gains will continue. Compounding this up = expectation-of-up attitude are the following erroneous beliefs…
Size doesn't matter
False. Successful, growing companies run through a "sweet spot" where they gain resources, clout and recognition that produces large, exciting gains. Eventually, however, the "law of large numbers" (see this NY Times article) bears down, making it progressively harder to produce similar growth (i.e., percentage gains in sales and earnings).
Competition cannot catch up
False. Success (especially from new markets and inordinately high profit margins) begets competition, both from those trying to one-up the product and from those trying to undercut the price. Moreover, as a company grows, it must not only successfully create more new, large-market products but also successfully defend its past products and markets from competitor encroachment. This is when high profit margins get chipped away.
Apple today has the characteristics of Apple yesterday
False. Fast growth changes a company's environment from a scrappy, focused, collegial, exciting workplace to a more typical corporate environment, with labor and projects divided among ever-larger groups overseen by layered management. Apple now has 60,000 employees and growing.
Apple's "cool" image = loyalty and pricing flexibility
False. Consumers are fickle. Undying loyalty and enthusiastic support can dissipate quickly when a new, shiny something appears (regardless of the source) - or, if a similar product can be had at a lower price.
AAPL is a $545 stock, up 35% from $405 this year
Those numbers, while correct, hide the reality. Apple's #1 market cap value is now $508 billion. 2012's $140 price gain = $130 billion market cap gain in only 2+ months. For comparison, McDonalds' (MCD) total market cap is $99 billion.
Therefore, to understand what those aggressive price projections of $600, $750, $1000 and $1500 really mean, we need to view them in market cap terms: $560 billion, $700 billion, $932 billion and $1.4 trillion. This graph shows how unrealistic those projections are.
(Source: Financial Visualizations - FinViz.com)
AAPL's price graph is a positive indicator
False. A rapid rise with low volatility always produces misleading feelings of excitement and the expectation of easy money with little risk. Here's the proper way to view this year's run-up and its heightened risk:
Apple is cheap
False. To be cheap in this stock market, AAPL would need to be misunderstood, ignored or disliked. Rather, it is a favorite holding among individuals and institutions, and virtually every investment organization analyzes it positively. In fact, to the extent over-optimism is at work, AAPL should be viewed as over-priced, not under.
The bottom line
No company, including Apple, is immune to the laws of corporate size and growth. Plus, other conditions (e.g., competitors) don't hold still. Success is a never-ending battle that is never won by any one organization.
In spite of those facts, AAPL has been acting like a small cap growth stock this year. Its thrilling run-up has caused Apple investors to stop worrying and start believing that ever-larger gains are inevitable.
So, what now? The key is to realize that over-optimism is driving the stock price now. Will AAPL's mini-double top signal the end of the uptrend, or will the stock break through to $600 and above?
The answer is unknowable. The important point is to understand that hanging on for more quick gains is playing a high risk game of guessing when the over-optimists' buying power will sag and sellers will gain the upper hand.
Instead of worrying about an opportunity loss (i.e., the "risk" that the stock rises after you sell), remember Bernard Baruch's winning strategy: "I made my money by selling early."
Additional disclosure: Positions held: Cash reserves and long inverse (short) commodity ETFs. Sold Apple recently at just under $500.