Watch Out for the Dead-Cat Bounce

by James Brumley | August 6, 2012 9:30 am

If you’re like a lot of investors, you’re less concerned about the fact that Starbucks (NASDAQ:SBUX[1]) shares are currently in the midst of what is (so far) a 17% freefall, and are more enamored by the fact that you can now “buy the stock at a 29% discount compared to where it was in April.” After all, cheap is better than more-expensive.

Or if it’s not Starbucks, then maybe it’s Hewlett-Packard (NYSE:HPQ[2]). The stock’s fallen from $29.59 in February to last week’s low of $17.41. That’s a 41% drubbing in 24 weeks, but Friday’s bullish move following Thursday’s struggles suggests the last of the selling is out of the way.

In fact, there are a bunch of stocks out there right now that have been hammered, and are “obviously” itching to rebound. Nokia (NYSE:NOK[3]), Research in Motion (NASDAQ:RIMM[4]), Dell (NASDAQ:DELL[5]) and Humana (NYSE:HUM[6]) are just a few names that have taken big hits of late, but seem destined to turn things around soon.

Funny thing about “obvious” though … it doesn’t always end up bearing fruit.

Before you dive into your favorite deeply-oversold stock, here are a few things you might want to consider:

Bottoms Are Elusive

Some of the same people who are suggesting Starbucks shares are now at a major low after sliding from $54.20 three weeks ago to Friday’s close of $43.91 are the same folks who were saying SBUX was at a major, buy-worthy bottom in mid-May after the stock fell from a peak near $62 in early April to that mid-May low of $51.53.

[7]Yes, we did see a dead-cat bounce; within a week Starbucks shares had rallied around 8% off that low. That was as good as it would get though, as the stock simply peeled back to ultimately set up the recent tumble to a low around $43.

Humana’s story is a similar one. Plenty of investors thought the worst-case scenario was fully baked in when shares fell from the $88 area in late April to a low of $74.53 in mid-May after the company warned its Q2 numbers wouldn’t be great.

As it turns out, the market opted to punish Humana again when the feared numbers became reality in late July. Since the end of June, shares have fallen from around $77 to Friday’s close of $62.70.

That’s a 16% plunge followed by nearly a 20% dip for essentially the same crime — the second leg of which many investors assumed wasn’t necessary, especially considering the stock’s only valued at 7.7 times its trailing earnings.

Sooner or Later, Fundamentals Matter

What’s the difference between a cheap stock and an undervalued stock? An undervalued name has good shot at actually justifying a higher price, while a cheap stock is cheap for a reason.

[8]It’s a distinction that will likely become the core argument regarding whether or not to scoop up shares of Dell or Hewlett-Packard. Remember, the former plunged from $15.08 to $12.49 on May 24, while the latter is down 37% since late February.

At the heart of the problem for both, however, is waning demand for laptops and desktops, and even weakening demand for printers and higher-end business or government networking equipment.

At some point the bleeding has to stop, and with DELL shares valued at only 5.8 times its forward-looking earnings (HPQ is valued similarly), surely there’s no more downside left to dole out, right?

Ehhh, not so fast.

The value is certainly there based on the earnings numbers, but the earnings outlook may be more of a hope and less of a certainty at this point. Both companies are hitting a wall, even if most investors aren’t seeing it.

Consider this: General Motors (NYSE:GM[9]) may be dropping HP is its key IT service provider[10]. Printer sales are reported to be slowing[11]. Dell has been on an acquisition spree[12] that’s looking a little more desperate than savvy. And both companies are well behind the curve[13] in the tablet race.

All-in-all, these are just a few reasons things are apt to get worse before they get better for both companies — the kinds of things to thwart a rebound before it really gets any traction.

The fact that the market has let these stocks slip to single-digit P/E levels is no mistake; investors have collectively figured out there’s still more risk than reward for these names.

Dead Cat Bounces Can Be Short-Lived

OK, assuming you have been able to find a name actually forming an elusive bottom, and assuming that brewing rebound is from a truly-underestimated stock, there’s still another pitfall for bottom-fishers: Dead-cat bounces don’t always last long enough to bother playing them.

[14]Take the way we saw FLIR Systems (NASDAQ:FLIR[15]) move last summer. Shares plunged from a high near $37 in mid-May of 2011 to a low around $22 by August — largely stemming from worries of an earnings dip that did indeed end up materializing.

But, at the time that quarter was seen as a one-time stumble, and the stock started to recover. By mid-September shares were back to $28, and earnings would indeed grow over the next two quarters. Yet FLIR shares stopped the rally by late September, and haven’t even tried to approach the $28 level again at any point in the meantime.

In other words, FLIR bounced, but in order to make any real money with the bounce trade, you would’ve had caught the exact bottom — and you would’ve had only a four-week window of opportunity to make any money with the strategy. That’s a lot to ask of a trader.

Bottom line? Distinguishing true rebounds from dead-cat bounces is tough enough on its own. To try and do it in this choppy market environment may be next to impossible.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities

  1. SBUX:
  2. HPQ:
  3. NOK:
  4. RIMM:
  5. DELL:
  6. HUM:
  7. [Image]:
  8. [Image]:
  9. GM:
  10. dropping HP is its key IT service provider:
  11. reported to be slowing:
  12. acquisition spree:
  13. well behind the curve:
  14. [Image]:
  15. FLIR:

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