Apple: Falling Knife or Rubber Ball?

It is rare for a stock's every move to be as closely followed as what we see happening with Apple shares over the last several days (and really, weeks). As we tick ever closer to the earnings release next week, opinions over the longer-term prospects of the company are equally fiercely divided. One school of thought thinks that the stock has the possibility to fall much lower, while others, myself included, believe that the stock is ready to buy.

The bear case
There is a trading expression that warns "never try to catch a falling knife," meaning that when a stock is really falling, trying to catch it at the bottom is a good way to get cut. The bears believe that Apple stock is just such a falling knife. These arguments are circulating, even against the backdrop of a greater-than-4% surge in the stock's price the day after its first close below $500 in about a year.

Central to the argument about Apple's downside is the idea that the stock was "over-owned." Apple was a top 10 holding of 800 funds that seemed to have no sense that a correction was possible. As some of those positions are unwound, now that the stock is soundly in correction territory, there has been significant downward pressure on shares. Additionally, because we are talking about institutional ownership, the selling may not be over yet. Despite this, however, the average of analyst targets has only fallen by 7% to $728, a full 33% above current levels.

In addition to the selling pressure created by funds leveling out Apple positions, there are real issues to be addressed. The story that seems to be old news -- and then news again -- is that the company reduced its orders to suppliers by as much as 50%. The report of this by The Wall Street Journal was one of the primary catalysts for Apple's sell-off to the sub-$500 level. If you take the timing out of the equation, there is the very real possibility that demand for the iPhone 5 is waning. This does not mean that Apple should give up on sales, simply that investors need to be realistic.

Other elements of the bear case include reduced sales from the rumor that a revamp of the iPad Mini and other Apple products will be released in March. Anyone on the fence about buying the device without the Retina display may well choose to wait, which could slow sales. Likewise, all of the buzz about the company's release of a "cheap" version of the iPhone 5 has countervailing arguments. Former Apple CEO John Sculley has come out saying that Apple must release a cheaper version of its phone if it hopes to compete in emerging markets, but there is little question that such a move would cannibalize some sales of the higher-margin iPhone 5. In general, the company has had some missteps that have warranted a correction.

The bull case
The arguments for buying the stock are equally plentiful. Under this scenario, the current sell-off can be seen as a "bear trap," drawing in those with a negative view before the stock runs higher. Even Google, which has not experienced the same correction that has plagued Apple, cannot boast the same low P/E multiple; at 11.4, Apple currently trades at roughly half of Google's 22.4 P/E. One might argue that the discrepancy is warranted given Google's dominant position in the smartphone market share race, but Apple's fundamentals are simply too strong to overlook. Google is a must-own stock without question, but the greater near-term opportunity is Apple.

Perhaps more important, Apple is expected to turn in its typical guidance beat next week when earnings are released. Where the company's guidance is for earnings per share of $11.75, the average sell-side analyst estimate is for $13.46 and the independents have it at $15.11, according the research of Fortune reporter Philip Elmer-Dewitt. Apple has a long history of under-promising and over-delivering, so an earnings beat will hardly come as a surprise to anyone.

From a trading perspective, however, the earnings release may be critical. On one hand, if the stock's downward inertia wins the day, earnings may be a case of "sell the rumor, sell the news." On the other hand, investors who have moved to the sidelines are likely looking for the right time to get back into the stock. Positive earnings news may be the excuse that these investors need to flood back into the stock. This could drive shares rapidly higher and leave you wondering what you were waiting for. Recall from above that the average price target remains at $728. Does this mean that those analysts have remained positive, or are they just slow to update their targets?

I like the rubber ball scenario, and I'd would be a buyer anywhere near $500. The stock's ability to quickly shrug off the sub-$500 close suggests that the stock is stronger than you might have thought. At current levels, I maintain that the upside disproportionately outpaces the downside.

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The article Apple: Falling Knife or Rubber Ball? originally appeared on Fool.com.

Fool contributor Doug Ehrman has no position in any stocks mentioned. The Motley Fool recommends Apple and Google. The Motley Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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