What happens when the leader can’t keep pace with the competition?  Well the obvious answer is that he no longer remains the leader…

For some time, Amazon.com Inc. (AMZN) has been in the good graces of a number of different economic participants.  Investors have been pleased with the exceptional rally which began well before the broad equity market bottomed in March of 2009.  At the same time, consumers have obviously been taken with the firm as revenue growth has continued throughout the financial crisis and has accelerated in recent months.  In fact, the fourth quarter reflected a 42% increase in revenue for the global internet retailer.

One additional group that has been very content with the firm is the number of affiliates who drive traffic and encourage sales on Amazon’s platform.  These affiliates (many of whom actually receive their primary income through this business line) are paid a commission for sales driven by their leads – a process which has been instrumental in the company’s strong growth.

But questions are surfacing in regards to the manner in which these affiliates and the sales that they generate are taxed.  Recently, Amazon actually cut off all affiliates in the state of Colorado after a dispute with how taxation matters will be handled.  This “nuclear option” will certainly be a negative for the company as far as sales growth is considered, but AMZN is willing to make this very public statement in order to pressure Colorado and other states to drop rules which will cause a financial or operational burden on the firm.

It will take some time for the logistics and regulatory issues to work their way through the system, but during an economic time where employment is under pressure, the US does not need additional red tape discouraging individuals from operating home businesses to generate income and promote economic activity.

Relative Weakness

From a trading perspective, AMZN is throwing up a number of red flags that will likely foreshadow weakness in the stock.  To start with, the stock has begun significantly trailing other retail names.  Now I understand that AMZN has some different dynamics than a typical brick and mortar retailer, but at the same time, the company is in the consumer area and has not been keeping pace.  While AMZN peaked in December of ’09, the retail index has continued to make new highs and is in a strongly trending pattern.

The underperformance of Amazon points to decreasing investor confidence and will likely lead to significantly lower prices once the retail sector begins to back off.  It probably makes sense to wait for RTH to break below the 20 day average or even the 50 day average before committing any serious capital to shorting AMZN.

Amazon is currently trading with a premium multiple.  Analysts expect the company to grow earnings by 43% in 2010 – which leaves us with an estimate of $2.91 per share.  Based on today’s price, investors are paying $44 for every dollar that the company earns which is a bit excessive.  I question what will happen if the estimates for 2010 are decreased.

Free Email Trading Course

If Amazon issues guidance that fails to support analyst expectations, the numbers could easily be adjusted down to $2.50 per share which still represents a healthy 22% increase over last year.  But the surprise could cause investors to place a lower multiple on the stock – and a PE of 33 along with estimates of $2.50 per share would lead to a stock price of $82.50.  That’s quite a decline from the current level near $130.

Shorting individual equities is a tricky business.  It takes proper risk control and appropriate timing on both entry and exits.  The newly revised ZachStocks Newsletter is designed to help traders identify timely long and short opportunities and also monitors open trades with risk stop points and levels for taking profits.  For Amazon, the risk is still high that the stock will be carried by bullish retail investors who continue to add exposure.  So while the opportunity is exceptional, we are waiting for the retail sector to show weakness before initiating a short position.

Once the trade has been entered, it makes sense to use a stop point a bit above the most recent swing high (currently $134.20) and then to use a trailing stop as the trade shows a profit.  Along the way, aggressive traders can use days of exceptional weakness to take profits off the table, and retracements higher to add exposure back into the trade.  But I would use moving averages and a picture of the retail sector as tools for determining when the downtrend is in trouble.

In short, Amazon is over-priced and likely to disappoint.  The chart pattern is exhibiting weakness.  Retail should pull back at some point as unemployment continues.  And the combination of these forces will favor a nimble trader willing to sell short.

FD: Author does not have a position in AMZN

Enjoy this article? Sign up for the ZachStocks Newsletter,
Your source for Sound Market Commentary, Growth Stock Analysis and Successful Investment Strategies