Why have Rolls-Royce shares just fell back under £4?

Over the last two years, Rolls-Royce (LSE: RR) shares have displayed the strongest momentum I can remember for an established FTSE 100 company. They’re up more than 300% in just 24 months!

However, such momentum can be a double-edged sword. When a share price is consistently increasing, this can attract more investors and drive it ever 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 firm. And this can cause a sudden correction (a fall of more than 10%).

After recently reaching 429p, the Rolls-Royce share price has now dropped beneath 400p. Should I seize upon this dip to buy more shares? Let’s take a look.

Why is the stock falling?

As far as I can tell, there has been no news from the company to warrant the recent sell-off. And analysts remain overwhelmingly bullish. Of the 14 offering one-year price forecasts, the consensus is 447p, or 12% above the current 399p.

Only one analyst out of 17 presently has a sell rating on the stock.

Of course, brokers are often hyper-reactive to what’s going on with the share price. If it’s going up, they’ll start raising their targets, and vice versa. So some may now change their minds and turn bearish.

They remind me a little bit of those bookies at the race track who change the odds as more or less money is placed on particular horses, dogs, or whatever. It can all be a bit speculative.

More likely is that the shares are losing altitude due to reports that interest rates may be staying higher for longer than expected. In March, US consumer prices rose 3.5% from a year ago, more than expected. So there’s probably that.

Defence shares are falling

Another probable factor here is that it’s been a bad few days for European defence and aerospace stocks in general.

Shares of BAE Systems, which have also been on fire over the past two years, have pulled back 4.8% since 8 April. Meanwhile, Germany’s largest arms firm, Rheinmetall, has seen its share price fall nearly 6%.

Rolls-Royce’s defence unit accounted for almost a quarter of group revenue last year. So there’s probably this sector-wide sell-off contributing to the fall as well.

Actually, I find the timing of this drop in defence stocks somewhat surprising. Sky News today (11 April) reported that an Iran attack on Israel could be “imminent“.

Given such disturbing geopolitical developments, I can only see defence shares heading higher.

Should I buy this dip?

There’s more to Rolls-Royce than defence, of course. Its civil aerospace division has the wind in its sails, with large engine flying hours this year projected to reach (or perhaps exceed) pre-Covid 2019 levels.

Is this rosy outlook already priced into the stock, though? Probably, in my opinion. It’s trading on a forward price-to-earnings (P/S) ratio of 27.6. That doesn’t seem to leave much of a margin of safety.

Long term, I’m still bullish on Rolls-Royce stock. I’d just like to see it come down a bit more, which is entirely possible given how fickle market sentiment can be.