Climbing a Wall of Euphoria

11/11/2009 1:00 pm EST

Focus: STOCKS

Joseph Hargett

Financial Analyst, Schaeffer's Investment Research, Inc.

Joseph Hargett of Schaeffer’s Investment Research says online retail giant Amazon.com has a high P/E ratio and a very bullish following.

Amazon.com's (Nasdaq: AMZN) recent post-earnings surge caught many investors off guard.

In fact, with the shares now trading with a price-to-earnings (P/E) ratio in the 77x region, some traders are downright concerned. However, as author Mark Hulbert states in this recent article from MarketWatch (“Amazon and the Nifty Fifty,” October 27), "we might not want to be too quick to dismiss Amazon.com's recent strength." For his reasoning, Hulbert cites the so-called Nifty Fifty stocks from the early 1970s.

Per a recent study by Jeremy Siegel, finance professor at the Wharton School of the University of Pennsylvania, "a portfolio that bought all 50 stocks at the stock market's peak in December 1972, and held them for at least two decades, would eventually have taken the lead over the broad stock market."

Hulbert also notes that it took years for the Nifty Fifty to justify their elevated P/E ratios from the early 1970s. Still, he believes that "Amazon.com's new record high is a harbinger of good things to come many years down the road for those beleaguered investors who are still nursing the wounds they suffered earlier this decade from the bursting of the Internet bubble.”

In the long run, Hulbert may eventually be proven correct in his bullish leanings toward AMZN, but there are some serious short-term concerns that must be considered before jumping on the bandwagon.

While we tend not to focus on P/E ratios at Schaeffer's Research, let's take a moment to put AMZN's current ratio in perspective. AMZN's P/E ratio comes in at somewhere near twice the next highest reading from a related company, which, from a contrarian perspective, has to send up at least a few warning flags for potential investors.

Other warning flags can be seen in the stock's sentiment backdrop. Specifically, AMZN's Schaeffer's put/call open interest ratio (SOIR) of 1.00 ranks below 72% of all those taken during the past year, meaning that options traders have rarely been more bullish toward the shares. What's more, 12 of the 21 analysts following AMZN rate the shares a Buy or better.

In fact, the only group that wasn't in AMZN's pocket was the short-selling community. Currently, more than 5% of the stock's float is sold short, following a [recent] 9.5% plunge in short interest. In all likelihood, these bears were blasted out of their positions in the wake of the company's better-than-expected quarterly earnings report, creating a short squeeze that contributed to AMZN's 26% post-report rally.

AMZN traders will want to keep a keen eye trained on the $118-$118.50 region. A breach of [that] region, which marks AMZN's earnings-gap close, could send the shares quickly down for a test of support near $111-$110, the security's earnings-gap low on October 23rd. (It closed above $130 Tuesday—Editor.)

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