AOL, S&P and the Stock-Market Twilight Zone

Two analysts say the stock may be disconnecting from the fundamentals.
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Two sell-side analysts bullish on

America Online


say its zooming stock has come unmoored from underlying fundamentals, but they disagree about what's driven the recent run-up.

The debate is complicated by AOL's recent entrance into a stock-market twilight zone:

Standard & Poor's

last week said it would add AOL to the widely tracked S&P 500 index, but AOL won't officially join the index until the market closes tomorrow.

Even after a pullback this morning, AOL shares are more than 35% ahead of their midmonth levels. But even before this week's journey from 136 5/8 to 157 1/4 (and part of the way back), Lise Buyer of

Credit Suisse First Boston

cut her rating on the stock to buy from strong buy. In a report issued the day after

Standard & Poor's

said it would add AOL to the S&P 500, Buyer, whose firm has no underwriting relationship with AOL, said the strong-buy rating applies to stocks "where we can do the math to justify a significantly higher target" -- or a 30% premium to its price. AOL still has upward momentum, Buyer wrote the day after the stock jumped 21 points to 138, but "fundamental analysis is currently less helpful."

So as with other Internet stocks in this situation, a buy rating is more appropriate, she says. "Things are going well for the company," she adds. The buy rating "is not meant to be a covert hold."

Rather than numbers, says Buyer, several other factors are governing AOL's stock price. One is optimism in the face of uncertainty about the potential of the online market. "It could be tremendous," she says. "None of us really know how big the whole industry will be." Meanwhile, investors have been bombarded with information about the growth of e-commerce. "It's hard to miss the headlines every day," she says. Finally, companies like AOL are growing as fast, if not faster, than analysts have predicted. "These stocks are working," she says. "The companies continue to surpass expectations."

Abhishek Gami, an analyst with

William Blair

, says AOL's volatility results from a scarcity of supply that arose in the days preceding the Dec. 22 S&P 500 announcement -- a scarcity that's new to AOL but common to other big-name Internet stocks like

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"There's a supply-demand dynamic going on that we haven't seen in the past," he says. (Gami rates AOL a buy. William Blair hasn't done underwriting for AOL.)

If there is a squeeze in the trading liquidity of AOL, it would imply no small demand. Collectively,, eBay and Yahoo! have a float of more than 63 million tradable shares worth about $18 billion, according to statistics from

Market Guide

. But AOL's float is more than 334 million shares and worth about $50 billion. A recent report from

Merrill Lynch's

equity derivatives strategy department estimates that AOL's transfer to the S&P 500 from the

S&P MidCap

index will mean a net purchase of $2.92 billion in AOL stock by index funds.

The S&P announcement did bump up AOL's stock, says Buyer. "That absolutely contributed," she says. But she disagrees there was a shortage of AOL shares to buy in recent days.

Trent May, portfolio manager of the


Invesco Growth fund, which holds AOL, agrees. "I don't think it's a liquidity squeeze that's driving the stock up," May says. He attributes the rise to a number of reasons, such as people front-running the S&P 500 change ahead of index funds, and the legitimacy that the S&P addition confers on AOL, no matter how much attention it has garnered in the past. "It opens up a whole new group of people that are focused on the space," he says.

Whatever the reasons for the stock's rise, the run-up of the past few days could be temporary, says Diane Garnick, the equity derivatives strategist who authored Merrill's report. "While we've seen AOL have tremendous gains since the announcement," she says, "all other things being equal, we expect the significant gains in AOL to subside once it is added on Dec. 31."

Surveying S&P additions from 1990 to 1998, Merrill found that added stocks outperformed the index the day after they were announced as additions, the day they were actually added and in the waiting period in between. But the new stocks underperformed in the days following the actual index change. This was true whether one looked five, 10, 20 or 30 trading days after the change. And as with the rises, the effects were more pronounced in 1998 than they were in previous years. For example, while stocks new to the S&P 500 underperformed the index by 2.8% over their first 30 days in the years before 1998, they underperformed by 8.5% in those same 30 days in 1998.

"I would not classify it as a liquidity squeeze," Garnick says. "Certainly AOL has not been the only Internet stock to fly this high these past few days."