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Stocks have pulled back since the calendar flipped to 2014. But fresh off a banner 2013, many stocks remain overvalued.
Wall Street pundits have been calling for a pullback for months. Still, U.S. stocks kept rising to new all-time highs on almost a weekly basis. By the end of 2013, the S&P 500 had risen 30% – the index’s largest one-year return since 1997. Now the tide has turned.
The S&P has fallen 5% so far this year, only the second such pullback in the last three years. The pundits were right – ultimately, a correction was inevitable. It was just a matter of when. Stocks never rise continuously without an occasional pullback.
The recent pullback notwithstanding, some stocks are still overbought. As a whole, the S&P is trading at a very reasonable level of 15x 2014 earnings. But not all stocks are created equal.
The rising tide of last year’s bull run lifted many boats – including some stocks that didn’t necessarily deserve it. Some stocks were simply along for the ride. In many cases, that ride took them further than their earnings (or lack thereof) would warrant. Now that volatility has returned on Wall Street, many of these risky stocks are likely to come crashing back to earth.
We at Wyatt Investment Research refer to these risky stocks as “landmines” – ticking time bombs that could have a devastating effect on any investment portfolio.
In order to avoid such risky stocks, you must first identify them.
How to Avoid Risky Stocks
Here are three common characteristics of potential “landmine” stocks:
- Unsustainable P/E Ratios. There is no real cutoff point for when a P/E ratio becomes too high. Tech stocks, for example, often trade at much higher P/E ratios than low-risk utility stocks. But I think we can all agree that a P/E of 50 is too high. Any stock that trades at more than 50 times forward earnings is in dangerous territory. Some risky stocks trade at high valuations for years. More often than not, however, high price-to-earnings ratios are difficult to sustain if profits aren’t growing at lightning speed. If you see a forward P/E above 50, that’s a red flag.
- Tiny Profit Margins. Profitability is the key to any company’s growth, and thus the key to any stock’s long-term performance. Sure, some upstart social media or biotech stocks can achieve major short-term returns on the promise of big things to come. But eventually, all companies have to prove to investors that they can make money. A risky stock that looks like a strong speculative play one day can quickly become stale if it’s struggling to turn a profit. And a low profit margin is a sure sign of a company that’s just scraping by. Be wary of any company with a profit margin of 10% or less.
- Huge Recent Returns. Huge returns are every investor’s goal. Finding a stock that will double in a year is essentially why investment newsletters like this one exist. But you don’t want to be late to the party. If you see a stock that has risen more than 100% in a year, it’s best to leave it alone. After all, “buy low, sell high” is the first rule of investing – not the opposite. Some stocks that have posted major gains in a short amount of time will continue rising. Those, however, are rarities on Wall Street. And they’re not worth the risk.
Any one of the three aforementioned characteristics should at least give you pause before deciding to buy a stock. If you see a stock with all three of these red flags, run very quickly in the opposite direction to avoid stepping on the landmine.
Entering the New Year, there were exactly 20 mid- to large-cap stocks that fit this so-called landmine criteria. And we have identified them all in a report we’re calling, “20 Stock Landmines that Could Destroy Your Wealth in 2014.”
To read more about these risky stocks, click here. Until then…