Trader Talk

Cupcakes and other momentum stocks gone bad

JB Reed | Bloomberg | Getty Images

I awoke this morning to emails alerting me to a BIG STORY. This is one of those stories that is a METAPHOR for the broader stock market, so pay attention, you morons who don't understand metaphors.

Which would be me.

The story: Crumbs Bake Shop (CRMB)--supposedly the world's largest cupcake company--closed its doors last night after being delisted from the NASDAQ on July 1. It went public with a bang in 2010, charging $4.50 a cupcake. It rapidly expanded to 65 stores, and then discovered...anyone can make a cupcake! And sell it for less than $4.50 a pop.

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The stock went from $ $0.04.

This, I am told, is a metaphor for the rest of the market. If not that, then it's a metaphor for momentum stocks.

Beware, I am told, of getting too ga-ga about businesses that can be easily disrupted.

What? My beloved Pandora (P) is kind of like...a really expensive cupcake?

I normally laugh at these kind of mindless analogies, but really, think about it.

Biotech down. Solar stocks down! Oh my god, the market is correcting!

Calm down. Biotech and solar stocks do not represent the stock market. They represent a tiny sliver of the market: Small-cap momentum stocks. And they are not even the most important part of that market.

More important are the internet/social media stocks that are again showing signs of stress. This is the second time this has happened, after a decline in March and April.

Good. Someone is finally starting to ask some reasonable questions. Like, exactly how much are we paying for this stuff?

Pandora (P) is trading for roughly 155 times forward earnings--this when the S&P is trading at roughly 15 times forward earnings. Ten times the S&P multiple!

YELP (YELP) is at 70 times. Groupon (GRPN) is 66 times.

These are small-cap names (all $4-$6 billion in market cap) that occupy far more attention than their size would dictate is reasonable.

But even bigger cap internet/social media can have silly valuations. Netflix (NFLX) is 109 times forward earnings. Facebook (FB) is at 43 times. LinkedIn (LNKD) is at 95 times earnings.

Get the point?

We all know that much of the growth in the last year--probably half--is due to multiple expansion rather than earnings growth.

You get multiple expansion when investors believe additional value has been created in a company.

But with momentum stocks, at some point, multiples almost invariably get stupid.

And investors start to question whether they are getting this right. And that's what's happening now with a lot of the internet/social media names.

Good for them! Good for all the people who are saying, "Pandora at 155 times forward earnings? Really? Is there some way we can continue to justify this?" Maybe. Maybe not.

That's what they should be asking!

This is why I hate momentum stocks: Because most of the trading is done by guys who don't give a rat's butt about multiples, or multiple expansion...they only follow trends. And if they can make money on a stock that moves a lot, particularly in one direction, well that's what we're here for!

Until one guy in a hundred says, uh, Pandora at 155 times earnings? Really, fellas?

Then the other 99 get that deer-in-the-headlight look. Uh-oh. Are we doing something stupid?

Momentum stocks have unique problems. These stocks have a large percentage of their float held by "weak hands," traders who will cut bait and run at the first sign of trouble.

The Facebook lovers will scream at me and say, "Pisani, you idiot, we are not buying Facebook on a one-year forward multiple! We are much smarter than that! We are buying it on earnings of 2017, and even 2019!"

"Really? You believe you know what Facebook's earnings will be three years from now?"

"Yes! We have estimates! They are, uh, right here, on our Excel spreadsheet..."

Whenever I hear this, I am astonished. Because I have been a financial reporter for 24 years, and I am at least humble enough to admit I am not very certain about what will be happening in the next QUARTER, let alone what will be happening in 2017 or 2019.

No matter. There are, obviously, far more intelligent people than I who are willing to throw a lot of money at...a spreadsheet from the future. A miraculous piece of paper from 2017.

Good for them. That's what makes a market.

As for the rest of the market, we have seen a MODEST move up in earnings from a year ago and a MODEST multiple expansion. I will worry about the broader market when names and sectors that do not have stupid multiples begin to break down on heavier volume.

Until then, pass the cupcake.