Henry Blodget has been proven correct for all of the wrong reasons. In the late nineties, Blodget made a name for himself as an unforgiving cheerleader of technology stocks. As an analyst, Henry Blodget's infamy peaked in December 1998, with what was a then outrageous $400 price target on Amazon (AMZN). Adjusted for January 1999 three for one and September 1999 two for one splits, Blodget's call amounts to $67 in today's dollars for Amazon. Although Henry Blodget's original mark appeared far removed from common sense, Amazon shares more than doubled in price one month after Blodget's call and surpassed $400 en route to separate April and December 1999 twin peaks at $600 (today's split adjusted $100). Amazon stock, of course, crashed and burned two years later, when it touched a nadir of $6.70 ($40 adjusted to Blodget's call) in October 2001 amid the dot-com bust.
Today, Amazon shares change hands at $250. Juxtaposed against the hysteria of Blodget's $400 call, Amazon is now worth $1,500 in 1998 dollars. Compared to underlying business performance, Amazon shareholders operate within a Twilight Zone beyond reality. Although Amazon stock is clearly overvalued, going short remains a dubious proposition, where potential risks far outweigh possible rewards. According to economist John Maynard Keynes, "the market can remain irrational longer than you can remain solvent."
The Economics of Shorting Stock
When shorting Amazon stock, traders borrow shares from other investors and immediately sell out of these positions for cash. At a later date, short sellers re-enter the market to rehypothecate, or buy to cover stock, and replace the original loan. These short sellers will profit if Amazon shares were to decline in price. Theoretically, share prices range between zero and infinity, which affords unlimited risk to short sellers. Today's technology stocks are privy to another round of "irrational exuberance" heavily financed by the Federal Reserve Board. Juxtaposed against anemic United States GDP growth, we are dealing with the most maddening equity bubble in history.
The Federal Reserve Board
The Federal Reserve Board observes a contradictory dual mandate of full employment and a stable price level to manage the U.S. economy. To meet these ends, the Federal Reserve effectively serves as the lender of last resort at the discount window, articulates banking reserve requirements, and trades government debt through open market transactions.
Amid recession, The Fed enters the open market to purchase U.S. Treasuries. These transactions increase the money supply and lower the cost of money as interest rates. Government officials then hope that private citizens and institutions will borrow cash and direct this spending power towards consumption, labor, financial investments, real estate, and capital projects. When the economy recovers, the Federal Reserve will re-enter the open market to sell off government debt and restrict the money supply. Practical measures are necessary to corral inflation and asset bubbles, before the inevitable collapse, or short-term correction of the financial system.
Logic indicates that the Federal Reserve will demonstrate bias towards cheap money policy. Nominal economic statistics are more attractive to the superficial eyeball test in comparison to real growth data, or information that subtracts out inflation. Furthermore, the financial industry of Too Big to Fail Banks, insurers, and real estate businesses account for roughly 25% of U.S. gross domestic product. Financials profit through the "spread," where they invest borrowed money into relatively high-yield investments. In response to the 2000-2002 dot-com bust, September 11 attacks, 2008 credit crisis, multi-billion dollar bailouts, and historically intense political polarization, Ben Bernanke is now forced to take the term "cheap money" into unchartered territory.
On September 13, the Fed detailed plans for its third quantitative easing program. For QE3, the Federal Reserve will purchase $40 billion in mortgage-backed securities every month, indefinitely. Taken together with current bond buying program, Operation Twist, the Fed will take on at least $85 billion in debt each month. These bolt-on purchases above an already bloated $2.8 trillion Federal Reserve balance sheet further highlight structural deficiencies within the U.S. economy. Paul Volcker, former Fed Chairman, describes QE3 as the "most extreme easing of monetary policy."
The Dow Jones Industrial Average levitates at multi-year highs above 13,000, while unemployment rates also remain persistently higher than 8%. Meanwhile, conservative savers are forced to eat negative real returns on money market accounts, certificates, and short-term bonds that yield less than 1%. In this environment, money will flow into speculative equities, such as Amazon, and inflate asset bubbles. Only time will tell, when exactly this gravy train will end.
The Bottom Line
At $250 per share, Wall Street values Amazon at roughly $115 billion in market capitalization. Despite the rapid advance in stock price, Amazon profits are decelerating sharply. For 2011, Amazon closed out its books with a relatively meager $631 million in net income. In 2010, Amazon posted $1.2 billion in profits. This year, for the six months ended June 30, Amazon is taking in $137 million in earnings. This 2012 mark is less than half of Amazon's 2011 business performance, when this corporation recorded $391 million in profits for the same six-month, year-over-year period. Amazon trades for 182 times 2011 trailing earnings and more than 350 times current earnings. Peter Lynch considers a stock fairly valued if it carries a price / earnings to growth rate of one. According to Lynch's metric, Amazon stock and the term "fair value" are nowhere near the same ballpark.
For the sake of comparison, Apple stock now changes hands for $667, which calculates out to $620 billion in market capitalization. At this share price, Apple (AAPL) trades for twenty-four times 2011 trailing earnings. For the past nine months ended June 30, 2012, Apple records $33.5 billion in net income. At this pace, Apple is averaging more than 66% annual income growth over the past four years, but the stock only trades for less than fifteen times current earnings.
Amazon cheerleaders, of course, will take a page out of Henry Blodget's book and highlight top-line revenue growth. Between 2009 and 2011, Amazon's total net sales nearly doubled from $24.5 billion to $48 billion. This year, Amazon's historically torrid revenue growth is showing signs of slowing. For Q2 2012, Amazon posts $12.8 billion in revenue, which is a 30% advance above Q2 2011, when this company took down $9.9 billion in sales. Long-term shareholders must reason that Amazon can slash costs to improve net income and justify today's outrageous valuations. In the case of the Kindle, however, Tim Worstall and Forbes deconstruct an Amazon modus operandi to dump product on the market at cost, in order to sell off cheap content. This business model forever dooms Amazon to operate as a high turnover / low margin Internet business.
In any scenario, Amazon is overvalued and shareholders should consider dollar-cost averaging out of this stock. Opportunistic bears must also avoid the financial risks of an Amazon short sale position exposed to extremely accommodative Federal Reserve policy and the mob-like groupthink of inefficient financial markets. John Maynard Keynes would pass on this bet.
Disclosure: I am long AAPL.