Cautious Look at Apple

03/19/2015 9:00 am EST

Focus: STOCKS

Joon Choi

Senior Portfolio Manager, Research Analyst, Signalert Asset Management LLC

Joon Choi, contributing editor of Systems & Forecasts, looks at the new changes impacting the Dow Jones Industrial average as the iPhone maker replaced Ma Bell.

Apple (AAPL) is replacing AT&T (T) after the stock market closes on March 18. The reason cited for the switch is due to Visa (V) stock splitting, leading to a decreased exposure in the information technology sector. Apple was chosen to fill the void created by the stock split.

But I believe the real reason for the stock switch is to address the lagging relative performance of Dow Jones Industrial Average to other broader indices such as S&P 500 in recent years.

When the index committee replaced three members of the Dow Industrials in 2013, the average had been lagging the S&P 500 Index for three out of the prior four years.

The three new members had much better performances than the ones dropped during the year leading into the replacement date; 46.1% vs. 25.1% respectively.

But the new additions underperformed the old members after the switch; 33.2% vs. 47.5% respectively. Chasing performance backfired, resulting in further Dow underperformance.

It seems like the committee is chasing performance once again. And, in my opinion, Dow Jones may be adding Apple to the Industrials at the wrong time, as I believe the stock may experience a sizable pullback because of the following reasons:

Apple's P/E ratio is diverging from price action.

Apple’s price has made a higher high recently but the P/E ratio has made a lower high, thus forming a negative divergence. Prior to the 45% selloff in 2012, Apple’s price and P/E ratio had formed a similar pattern.

I see too much complacency.

It seems like everyone is bullish on the stock which can be seen in Apple’s short interest ratio, which is near its lowest level in last five years.

Moreover, the ratio has formed a downward sloping wedge, which may be a sign that short interest may reverse the downtrend soon, leading to a selloff.

Apple is one of the most beloved stocks among retail investors.

I am reading countless articles about how many individual investors have bought and held Apple stock for huge gains.

In addition, many analysts are recommending Apple for the long haul citing lofty target prices. Meanwhile, institutions have reduced their holdings.

In summary, I believe the real reason for the switch is to chase performance and stop lagging the S&P 500 Index. 

However, the Apple addition comes at the wrong time as price and P/E ratio are diverging, investors are overly optimistic, and institutions are decreasing their share of the stock, all signs that a sizable selloff may be in the cards for Apple.

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