Image source: Getty Images
During the last two years, Rolls-Royce (LSE:RR) shares have shown the strongest momentum I can remember for an established business FTSE 100 company. They are up over 300% in just 24 months!
However, that impulse can be a double-edged sword. When the price of a stock rises steadily, this can attract more investors and drive it even higher. That's great for existing shareholders.
But this can quickly lead to overvaluation, where the share price becomes disconnected from the underlying fundamentals and prospects of the company. And this can cause a sudden correction (a drop of more than 10%).
After recently reaching 429p, the Rolls-Royce share price has now fallen below 400p. Should I take advantage of this drop to buy more shares? We'll see.
Why is the stock falling?
As far as I can tell, there has been no news from the company to justify the recent liquidation. And analysts remain overwhelmingly optimistic. Of the 14 that offer one-year price forecasts, the consensus is 447p, or 12% above the current 399p.
Currently, only one out of 17 analysts has a sell rating on the stock.
Of course, brokers tend to be very reactive to what happens with the stock price. If it is going up, they will start to increase their goals and vice versa. That is why it is possible that some will now change their minds and become bearish.
They remind me a little of those bookies at racetracks who change the odds as more or less money is placed on particular horses, dogs or whatever. It can all be a bit speculative.
stocks are most likely losing height on reports that interest rates could stay higher for longer than expected. In March, US consumer prices rose 3.5% from a year earlier, more than expected. So there's probably that.
Defense stocks Are Falling
Another likely factor is that it has been a bad few days for European defense and aerospace stocks in general.
Actions of BAE Systems, which have also been booming for the past two years, have fallen 4.8% since April 8. Meanwhile, Germany's largest arms company, Rheinmetallhas seen its share price fall almost 6%.
Rolls-Royce's defense unit accounted for almost a quarter of the group's revenue last year. Therefore, this sector-wide sell-off is likely also contributing to the decline.
I actually find the timing of this drop in defense stocks somewhat surprising. Sky News reported today (April 11) that an attack by Iran against Israel could be “imminent“.
In the face of such disturbing geopolitical developments, I can only see defense stocks rising.
Should I buy this dip?
Of course, Rolls-Royce is about more than defense. Its civil aerospace division has the wind at its back, with large engine flight hours expected to reach (or perhaps exceed) pre-Covid 2019 levels this year.
However, is this optimistic outlook already factored into the share price? Probably, in my opinion. It is trading with a forward price-to-earnings (P/S) ratio of 27.6. That doesn't seem to leave much margin of safety.
Long term, I remain bullish on Rolls-Royce stock. I'd just like to see it go down a bit more, which is entirely possible given how fickle market sentiment can be.
