Earnings Season Massacres: The Risk of Overextension

Investors have clearly learned over the past few months that this is a market of haves and have-nots. The dichotomy is pretty easy to describe: Financials and Consumer Discretionary stocks, both of which are heavily exposed to the deteriorating conditions of the overextended U.S. consumer/borrower, certainly are dragging down index returns. Additionally, Industrials with heavy domestic exposure are scaring off investors as well. Yet, the market goes up, as investors enjoy a flood of liquidity and reallocate to those names that seem immune from the sub-prime contagion. This behavior of investors crowding into an increasingly smaller number of “Teflon stocks” is dangerous, as it leads the stocks to become overextended and vulnerable to any sort of disappointment. Witness some of the earnings season massacres detailed below.

Itron (ITRI) lost ¼ of its value last week, though it remains up 51% YTD. Notice that the forward PE had climbed from 26 in late July to 31 before the company disappointed. Investors believed ITRI to be immune due to its exposure to energy conservation.

Vasco Data Security (VDSI) had a small miss a couple of weeks ago, driving the stock down about 45%, though it remains up 107% YTD. Notice that the forward PE reached 50X, having expanded from a peak of 37X in July. Investors had expected this technology company with only 10% domestic sales to continue to produce stunning growth, and 60% wasn’t good enough.

Oil States Services (OIS) endured a surprising shortfall Friday and dropped 13% (now down 25% from the peak), opening investors eyes to previously undetected potential problems in the services industry.

While Crocs (CROX) is in the scary Consumer Discretionary sector, it had been performing quite well until it reported last week and promptly lost over 1/3 of its market value. The PE had expanded slightly from late July on very aggressive forecasts. The stock is still up 120% YTD.

WellCare Health Plans (WCG) didn’t report an earnings miss, but it too was one of the anointed ones, with its PE expanding from 16 in August to a sector-high 20 before the FBI raid. I include this example, which I had actually warned about way too early, because it illustrates the downside of hiding out in a “safe” stock that offers little downside protection.

I believe that investors have consistently underestimated the overall potential impact the unraveling of the mortgage credit bubble could have on stocks. I still maintain that ultimately it will lead to a bear market in all equities and that there will be nowhere to hide as credit contracts globally. Investors are playing a dangerous game of musical chairs, rotating into those names that appear, for now, to be immune from the contagion. This is momentum to the extreme, not too dissimilar to the behaviors of the late 90s. Perhaps some of these examples will highlight those risks.

Disclosure: No position in any of these names