Valuation Concerns for Apple Inc. (NASDAQ:AAPL)

September 03, 2014, 11:30 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

Pacific Crest recently suggested that investors in Apple Inc. (NASDAQ:AAPL) look to protect profits.  That has surprised many investors in Apple, but it could be based on an important understanding.  Valuation absolutely matters, and although the hacking incident may be forgotten (fixed) soon, the incident did open the door for analysts to reconsider their positions.

PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ) is noticeably weaker than SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) today, primarily due to the action in Apple (AAPL).  Shares of Apple are weak today, something that has almost been unheard of in recent weeks.  The strength and Apple stock has been consistent and it has been one of the main reasons the NASDAQ has outperformed the other markets so significantly over the recent months.

The surprising thing is that even with the recent strength the NASDAQ has still already broken its longer-term upward sloping channel, the one that began in early 2013, and the recent strength has only brought the NASDAQ back to test longer term converted resistance.  By definition when support lines break they become converted resistance lines, so the strength in the NASDAQ recently, fueled in part by the strength in Apple, has brought the market back to that trend line again.

The question is, is Apple doing the same thing?

Before I continue it is very important to recognize that Apple has already broken above resistance lines a number of times during the recent increases.  The stock has moved consistently higher, it has broken through resistance lines numerous times, and although new resistance lines form as the channels become steeper and steeper, the stock hasn't skipped a beat until, arguably, today.

So, what will it take for Apple to actually break down?

One catalyst could be general market pressures.  The markets are at levels that would be considered material turning points if the markets begin to turn down from them, but clearly the markets have not turned down yet.  They would need to do so in order to create market pressure on Apple, otherwise the general buying that has taken place will likely continue and money flows into Apple will as well.

Next, valuation clearly comes into play when negative news surprises the street like it seems to have done today.  When looking at shares of Apple from a valuation standpoint we can see that the yearly earnings growth rate for Apple has been about 9.33% recently.  In our evaluation we exclude onetime events to measure earnings growth from operations and we use trailing 12 month data in our comparison so that seasonal anomalies are discounted.

Given the recent yearly earnings growth rate for Apple, its peg ratio, which is a proper measure of valuation, is 1.77.  If Apple is able to consistently grow earnings at or around 9.33% this peg ratio will not seen out of line, but if the earnings growth rate for Apple declines from what it is now that peg ratio will increase unless the stock falls.

Therefore, pressure can be added to Apple if future earnings growth fails to come close to recent earnings growth results.  Make no mistake, recent earnings have been solid, especially for a company this size, but maintaining the earnings growth like that may be extremely difficult so there are questions still left to be answered.

The two potential catalysts, market pressure and lower earnings growth, seem to be the primary potential catalysts that could cause the stock to turn, but for now none of those are directly on the table.  The market is testing important levels, but turns down have not begun, and we do not yet know if Apple is going to continue to grow at or around 9.33%.

As a result, reasonably, the declines in Apple today, attributable to the icloud and incidents of hacking, will likely be forgotten relatively soon, but the incident did open the eyes of larger investors who have recently returned from summer vacations and they are now looking at valuation much more closely.

Our real time trading report for AAPL suggests that the stock is in a state of limbo at current levels, but within an upward sloping channel that is steep and still intact.  The stock would need to break that channel for technical red flags to surface.

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