Too Far, Too Fast?

Lucent, Dell and Gateway head a list of overvalued stocks


Just about everybody agrees that stocks look overly pricey these days. Indeed, Wall Street's near-universal nervousness was made clear last Monday when worries about slightly higher interest rates sent the Dow Jones Industrial Average skidding a full 146 points, or 1.6%. By week's end, of course, the market had recovered, but the jitters persist, and a lot of investors are wondering which stocks are the most dangerous right now. With that query in mind, we rang up the folks at Laszlo Birinyi's shop in Greenwich, Connecticut, to get a list of the 50 stocks in the Standard & Poor's 500 Index that looked most expensive by one important measure: The relationship between their current price and the average price they had fetched over the past 200 trading days.

This relationship is very important to technical analysis, a body of stock-market research that relies heavily on price movements and patterns as opposed to such fundamental factors as corporate earnings and sales. One of the most important tenets of technical analysis holds that stock prices cannot long remain at levels far above their 200-day moving average. This view applied to the overall market suggests that some sort of a correction is due. Right now the stocks in the S&P 500, for example, are trading 11% above their 200-day moving average.

But that's nothing compared to some of the stocks assembled in the nearby table. Among the most overvalued stocks by this measure are three of Wall Street's technology sweethearts: Lucent Technologies, Gateway and Dell Computer.

Other stocks at the top of our roster are Nacco Industries, a leading manufacturer of forklift trucks and home appliances that has experienced a rebound in earnings; Pfizer, maker of the wildly popular impotence drug Viagra, and Viacom, an entertainment company that has seen its stock surge because of burgeoning profits on its distribution rights to the movie Titanic and improved results at the company's Blockbuster video stores.

These are all well-run firms. In fact, a company's inclusion on the nearby list merely means that its stock has surged powerfully of late. There is no guarantee they will crash anytime soon or even stop rising, for that matter.

It's also worth noting that technology stocks are among the most volatile in the market, and they tend to trade in the widest band around their 200-day averages. At the other end of the spectrum are utilities, whose stock prices are usually fairly close to their 200-day averages.

The way to use a list like the one presented here is as a source of clues in trying to find which stocks have rallied beyond what their fundamentals warrant. The investors' job is to judge which stocks have been caught up in the market's frenzy and which ones have risen for good reason.

One stock that seems to be a bit ahead of itself is Lucent Technologies, now trading 59% above its 200-day moving average. The telecommunication-equipment maker recently reported earnings for the quarter ended March 31 had doubled to $159 million, or 12 cents a share, excluding nonrecurring items. The final profit, however, was only two cents a share because of a one-time charge for Lucent's acquisition of Prominent Corp., a maker of telecommunications switching equipment. This punk net-income figure helps explain Lucent's sky-high price-to-earnings ratio of 218.

When Lucent was spun off from AT&T two years ago, we at Barron's correctly predicted good things for the stock, and while that upward trajectory may resume at some point, a resting period seems in order about now.

Lucent shares began this year at almost $40 and had climbed to $74 by the middle of last week, making for an eye-popping 85% return so far this year. The recent run in Lucent's stock price has certainly caught the attention of Philip Sirlin, a telecom analyst at Schroder & Co. He downgraded the company's stock from "buy" to "hold" on April 23 because Lucent's stock had risen so sharply. Sirlin's price target for the stock is $77 a year from now based on his 1999 earnings estimate of $2.20.

In Sirlin's view, Lucent could fall and then trade back up to $77, or maybe it will just tread water for the next year. Needless to say, he thinks there are better places to invest new money.

"It was downgraded only because of price," Sirlin notes. "We still feel extremely positive about the company's fundamentals, but that doesn't mean you want to buy the stock."

Not far behind Lucent on the list you'll find Gateway and Dell, both trading 55% above their 200-day moving averages. Gateway stock started the year at $32 and now trades around $57, making for a 78% gain. Earlier this month Gateway reported a 12% rise in first-quarter earnings, which was better than expected. Sales rose 22%.

James Poyner, a senior computer analyst at CIBC Oppenheimer, has recently downgraded Gateway from "hold" to "underperform." He's worried about changes in the personal-computer industry, particularly the increasing popularity of PCs that cost less than $1,500. Gateway, unfortunately, is known for concentrating on pricier fare.

Poyner also expects Gateway's profit margins to stop increasing and perhaps shrink. He notes that rivals such as Compaq and IBM have been slashing PC prices. That, he believes, will hurt the entire industry. Margins could also come under pressure as the price of computer parts, which has been falling, could soon begin to flatten out or even rise.

Poyner has had a "hold" rating on Dell for more than a year, and so he missed out on much of the stock's increase. But he still believes the move to lower-cost computers and an increasing emphasis on service will start to hurt Dell's bottom line.

More recently, Kevin McCarthy, an analyst at Donaldson Lufkin & Jenrette, lowered his recommendation on Dell from buy to "market perform." His move was prompted by the announcement that Compaq would cut its PC prices. "I just think it's dangerous to assume that Dell could continue to operate in a separate environment from Compaq," he explains.

Even if price pressures have only a marginal effect on Dell, the stock could be hurt because it reflects such optimism. Just last week it was labeled "the last hot computer stock" on the cover of Fortune magazine, a dangerous indicator if ever there was one.

Dell's stock kicked off 1998 at $42, and last Wednesday, it hit $77, an 83% return for those who were lucky enough to buy at the turn of the year. Shares have responded to recent bullish remarks by Michael Dell, chief executive officer and founder of the Round Rock, Texas-based company. Dell predicts that his company will grow faster than the rest of the personal-computer market this year. The stock now trades at 30 times 1999 earnings estimates.

Besides using the 200-day moving average to look at individual stocks, analysts use it to gauge the condition of the overall market. Today, for example, 75% of the stocks in the Standard & Poor's 500 Index are trading above their 200-day moving average, according to the crew at Birinyi. In itself, that does not signal a hugely inflated market. One rule of thumb is that a market is clearly overbought if 80% or more of the stocks are trading above their 200-day averages. If 20% or less are trading above the average, then the market is considered clearly oversold.

Richard McCabe, Merrill Lynch's chief market analyst, notes that as the S&P 500 is hitting new highs, the number of stocks trading above their 200-day averages is actually decreasing. For example, only about 58% of New York Stock Exchange stocks are now trading above their 200-day average. That's well below the 85% seen early last October. But given the height of the market, this isn't necessarily a sign of sanity emerging. In fact, it means that fewer stocks are powering the market's recent rallies.

"That indicates the late stage of a bull market," McCabe says.

Such a pattern can continue for nine months to a year, and then it is often followed by a market decline of 15%-20%, he says. If more stocks don't start joining in the rally, McCabe expects a 20% drop, either later this year or in 1999.

Even Prudential Securities' Ralph Acampora, one of the biggest bulls on Wall Street, is calling for a short-term correction nowadays. Either the market can fall by 5%-10% or it can just stand still for a while until the 200-day moving average rises, he says. That would keep the Dow in a range of 8700-9200. But if interest-rate fears rise, the Dow could fall to 8200, he warns.

Despite such short-term concerns, Acampora remains a bull for the long run, holding to his forecast that the Dow will hit 10,000 or higher by year-end. "For us to correct here would be healthy," he says.

Salomon Smith Barney's Alan Shaw expects the market's choppiness to continue for the short term, and he will be watching to see if the market has enough strength to hit new highs on strong volume. Like Acampora, he expects the market to rally above the 10,000 mark by year-end. And for the very long-term, he also remains a bull. In fact, Shaw's studies show that the Dow could possibly vault to the 15,000-20,000 range between the years 2002 and 2007.

Now, there's a pleasant thought to keep in mind as the market gyrates during the next month or two.


  1. What does relative strength measure? How is it computed?
  2. What has to be true about stock price movements across time for relative strength rules to yield superior returns?
  3. Would you be more likely to use relative strength rules if you have a short or long time horizon ? Explain.