As the markets rally on the optimistic Eurozone developments, the high-beta cloud stocks are poised to move higher with them. I am a very strong critic of the high-growth, high P/E model for some of these stocks. Although some companies in the cloud sector do have solid fundamentals such as NetApp (NTAP) and F5 Networks (FFIV), many of the cloud stocks are hollow investments with no fundamentals to back their stock prices. The latter category includes many popular cloud stocks led by Salesforce (CRM), NetSuite (N) and RedHat (RHT).
Salesforce and NetSuite straight out lose money so they don't even have a P/E. RedHat does make a small profit but its valuation is nothing short of ridiculous at 75X P/E. All three of these companies suggest that their operations should be evaluated with adjusted earnings measures but even if investors accept those unreasonable adjustments the valuations are still in the 40X range which is still very high. Even the P/Sales ratios of these companies are outlandish (above 6X for most cloud companies and above 11X for NetSuite) if you consider that the P/S ratio of most cloud companies are higher than the P/E multiples of many solid companies in the market.
There is absolutely no question that these stocks are the bubble stocks of the post-financial crisis environment. However, my aim in this article is not to critique the bubble formations in the market. They are just a part of investing, and scoffing at them is not going to make them go away.
In my opinion, there is a huge trading opportunity for these stocks in June and July of 2012 though. My expectation is that these stocks will experience the latest stage of their bubble and reach their bubble peak in July of 2012. It is obvious that the sole motivator of the stock prices of these stocks is market sentiment. As the valuations are completely detached from the fundamentals, these stocks just go up abnormally when market sentiment is good, and they stagnate when market sentiment turns down.
The high market sentiment that comes with the Eurozone improvements will be the reason that blows the final stage of the cloud stock bubble, in my opinion. It is a known fact that bubbles go thorough one last and exponential stage before they pop. As high as the valuations are, the price trends indicate that cloud stocks have not yet gone through that last stage. July of 2012 will probably be that last stage of the bubble, possibly followed by a pop in August 2012 when Eurozone problems come back and hit the market sentiment.
The acquisition of BuddyMedia by Salesforce is another indicator that the companies themselves are also preparing for the pop-up of the bubble. These companies do pay unreasonable amounts in their M&A transactions, but so far most of them had used their operating cash flows to fund these transactions. The above mentioned acquisition by Salesforce had the distinction that the company started to pay up with money it didn't have (used financing to fund the transaction). It is my opinion that the company is aware that its high-flying days are almost over and it tried to make one last scam to make use of its financing capacity before its stock tanks and destroys its reputability. Such desperate moves by companies to squeeze out the most they can from a hollow reputation is usually an indicator that the company is in the last stages of its bubble formation and the end of it is near.
My trading suggestion is to go strongly long these three stocks to take advantage of the huge gains that are made in the last stage of the bubble before it pops. The risks are definitely not low in trying to catch that last exponential stage of the bubble, but the possible profits do justify taking that risk, in my opinion. To limit downside risk, use of call options might be appropriate in my opinion. That way investors can participate in the upside, without risking too much capital in case Eurozone problems come back quicker than expected.
I should note that in this last stage of the bubble, trying to arbitrage within the cloud sector by a long position in solid stocks such as F5 networks and hedging with a short position in high multiple stocks such as NetSuite, will probably not be a profitable strategy. Usually in the last stage of the bubble, the most speculative stocks are the most profitable stocks with more stable companies left stagnant.
Investors can simply initiate long positions in CRM, N and RHT. If call options are to be utilized, I would exclude RHT since implied volatility on the options of RHT is too high. For CRM and N, the below call options could be the profitable ones.
CRM July 20' 12 150 Call Option for $1.15
N July 20' 12 55 Call Option for $0.45
I will try to post another article when my analysis concludes that the peak is very near. Investors who find my trading suggestions of good quality can use the "Follow" feature of SA, to get that follow-up article.