Google Has Lost Its Alpha

| About: Alphabet Inc. (GOOG)
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I admire Google Inc. (NASDAQ:GOOG) in almost every way imaginable, however I think the stock is headed for a correction. That said, I still like Google long term. In April, I called a similar "trader's top" of Apple Inc. (NASDAQ:AAPL) which held for several months, before Apple went on to set a new high.

Reason #1: Competition

A new stock market narrative is forming: Facebook (NASDAQ:FB) as legitimate competition to Google. It's not new to say Facebook competes with Google in an abstract sense, it's not new to say they both do discovery, and it's not new to say Google+ is a joke of a social network. What's new is this:

Long-term, Facebook wants to "record every book, film, and song a person has ever consumed, then build a spectacular model of other things that person could enjoy."

Facebook is talking about making money by mapping, or "modeling" the entire Internet. No doubt, this has long been its plan, but pressure from investors is forcing Facebook to articulate the plan. Facebook isn't coming out and saying it directly, but its plan is to do the same thing Google does. The quoted sentence above will shape coverage of Facebook and Google in the weeks ahead.

The financial media is going to feast on this story, and rightfully so - maybe the model of the Internet should be a little more social, who is to say really? Wall Street has no way of knowing what will actually happen, but that has never stopped it from pretending.

Reason #2: Vringo

Vringo, Inc. (VRNG) is suing Google for search patents. If Vringo succeeds partially or fully, depending on the scenario, Google would pay a couple hundred million dollars or a couple billion dollars. Up till now, the Google stock has not shown any sensitivity to the litigation.

This week Google's request for Summary Judgment was denied. Analysis so far has focused on what this means for Vringo. It has meant an immediate move up of 70% in two days. So far, Google hasn't discernibly moved in tandem because Vringo is a much smaller company.

However, the recent VRNG market cap move was quite large: over one hundred million dollars. That is a sizeable move that puts the litigation scale in the universe of Google, as Google earns a couple billion dollars per quarter. The VRNG move means the litigation is no longer a significant risk to Google's short-term alpha - it is now a substantial risk.

It's hard to say what the actual risk is - it could be lower or higher. I'm just looking at the market narrative. Think of it this way: the market gave Vringo a bunch of money because it expects Vringo is likely to take a bunch of money from Google. But the market did not show a sign of taking any money away from Google. This differential could be self-contradictory and unsustainable, and it could resolve itself by GOOG absorbing a $100MM loss.

Yes, Google's market cap swings by $10BB every couple weeks, so it is not immediately threatened. But the long-term narrative of Google is threatened by the risk of patent trolling, and the short-term narrative of Google is threatened by earnings.

Let's say that ultimately the expected value of Vringo's lawsuit based on risk/reward is $300MM. Let's say the market turns the one-time lawsuit into a narrative about patent trolls. Suddenly, $300MM isn't being compared to Google's market cap of a quarter trillion dollars; suddenly, $300MM is being compared to Google's quarterly earnings of $2BB-$3BB, because suddenly patent trolls are coming out of the woodwork left and right.

I don't think Google is really threatened, but the momentum of its earnings narrative could be.

It might sound like I'm reaching here. Just remember what Google is based on. A bunch of smart engineers get in a room and build a product that is better than the pre-existing product from competitors. The one screw that could go in this machine? Patents protecting early engineers from superior ones.

Why Google Will Correct

Traders will weigh the risk/reward at current prices and trim their positions. The range trading of GOOG bull Jason Cimpl is representative of standard profit taking. He is bearish now. You can see from the chart his timing has been pretty good up until the latest rally.

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Alpha is driven by a numerator of reward and a denominator of risk. Google has broken its range, signaling a reward-driven rally. But this will be a risk-driven correction. Europe is not resolved, China is just starting its landing, Netanyahu drew a bright line on Iran, and there is no way to trust today's market to hold tech through volatility.

Imagine next week when all the big blogs are talking about Facebook replacing Google in modeling the Internet. Imagine a Wall Street Journal article with Mark Cuban talking about: Google could be giving Vringo a billion dollars next quarter. Imagine some macro "risk-off" scare throws the market back towards 2011. None of this is hard to imagine, and that's why smart money is taking profits. Google is not high-risk, but it is high-beta, and the market loves to confuse the two.

Long term, the Google story is strong, but short term, Google's story is more than fairly valued. Google is too big to shoot up quickly; if I'm wrong and more good news comes out, there will be time to buy into the continued upswing.

Two questions to prove my point:

1. Doesn't Facebook want to redeem its reputation?

2. Does it matter if Facebook is really a threat to Google - if the story dominates the news, won't the stock market take it seriously?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.