Apple's Drop Now Too Large To Ignore

| About: Apple Inc. (AAPL)

It looked like Apple (NASDAQ:AAPL) might be establishing a foundation at about $560. With the stock declining, this stopping point is important. The steady rise to $644 produced no clear support levels, and the stock needs a foothold to encourage investors and prevent frustrated selling. Then along came today's breakdown.

What next?

The way to offset the potential damage from today's sharp drop is to have an equally sharp reversal, regaining the $560 level. Such a rebound could reassure holders that the sell-off was a panicky reaction by weak shareholders and nothing more.

However, without an offsetting rise the stock is well below its high, yet has only weak support levels below: $525 = 100-day moving average and $520 = mini-support level where AAPL rested for three days in early March. Below those are weak levels in the $480-$500 area. The only "strong" support comes from a technical indicator that has worked for AAPL in the past: The 200-day moving average. The problem is it's far below, at $460, albeit trending upward.

(Click to enlarge)Apple stock chart - support levels

(Stock charts courtesy of

When does selling begin in earnest?

Barring the quick rebound, the growing unrealized losses are weighing on investors who bought at $600-plus. Their reasons for buying (excitement, quick gains and low risk) are weakening along with the stock. Without any negative news, the size of losses and the speed with which they grow are major determinants of selling. At 15% off its high, the stock is in a critical area.

Even if selling doesn't occur, those higher-priced holdings are a significant overhang that will bog down any upward move. A natural reaction for a worried shareholder with a loss now is to hope for a rise that would allow selling some or all shares near breakeven.

(Click to enlarge)Apple stock chart - overhanging stock purchases

What about the stock market?

A reasonable question is whether the stock market is the cause of Apple's recent slide. The answer is a fairly clear "no." AAPL has been on its own course since last fall, rising much faster than the market and even when the market was stalling or reversing. Since hitting its early April high, it has fallen much faster, regardless of the stock market's movements.

In fact, the reverse is true. AAPL, as the largest stock, affects the stock market indexes that include it. Apple's recent drop caused a separation of returns for the three major indexes. Apple's weight in the indexes are: DJIA = 0%; S&P 500 =~ 5%; Nasdaq =~10%.

(Click to enlarge)Apple and stock market performance comparison

The bottom line

AAPL is at a critical fork in the road:

One route has the stock establishing a foundation quickly, preventing any further price deterioration. With shareholders held in place, and the investment community regaining objectivity, fundamentals can again come into play. Provided company developments (and earnings) continue to produce positive surprise, investor buying could return, driving prices higher.

The other route has the stock falling further before hitting support. Likely this decline would be exacerbated by investors throwing in the towel and selling - particularly those who are part of the $600-plus overhang. Having touched the hot stove, they will be reticent to return anytime soon. To take their place and provide a sound foundation, seasoned, long-term investors are needed. To entice them, however, an attractive valuation (i.e., low price) is required. This means a deeper and lengthier weak period for the stock.

What about fundamental valuation support?

The argument is that Apple's fundamentals are so good that they should support the stock price, regardless of how the price chart looks.

The problem is that valuations are in the eye of the believers (and skeptics). A stock can trade within a wide range of valuations depending on the range of fundamental forecasts and whether the stock is hated, ignored, neutral, liked or loved. Apple was recently in the "loved" category, so it could easily fall in valuation as the investor perception turns more negative.

Moreover, the fundamental forecasts were recently highly optimistic (remember the leapfrog analytical forecasts, pushed out further into the future and producing ever higher price targets?). The natural and unique uncertainties of the technology industry and technology companies mean there is a wide range of possible outcomes, even for Apple. Moving away from optimism, forecasts can easily drop in amount and shorten in time horizon. Both changes would push down price targets.

Important: Note in the first graph above that the entire stock jump following last quarter's excellent earnings report is more than erased. This reversal is an indication of an ongoing adjustment in valuation analysis.

But Apple is cheap!

No, it's not. That was one of the simplistic mantras that kept investors buying without fear. I tackled the valuation issue last September (in "Apple Should Be Selling Much Higher, Why It Isn't"). My conclusion then was that Apple was, indeed, "special." However, its special strengths were accompanied by special risks.

As I described in my views over the past months, AAPL, as the largest stock with a broad, enthusiastic, optimistic, vocal following, cannot be labeled as ignored or misunderstood. Yet, those were the arguments given for why the stock was cheap, with the follow-on, "just wait until the masses catch on and begin to buy." Now, with the trend broken, the question is "How low can it go?"

(Click to enlarge)Apple stock chart - trend broken

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Positions held: Long U.S. stocks and cash reserves.