101 Reasons the Market Looks Overheated Today

Please raise your hand if some of the stocks you own have gone up a lot recently. Mmmhm. Yep, that looks like just about everyone. OK, you can put your hands down.

I'm all for straw polls, but just to investigate this phenomenon with a bit more precision, I've conducted a screen for stocks listed on major U.S. exchanges that have more than doubled, on a dividend-adjusted basis, since the end of August. As of Monday, a pretty amazing 101 stocks make the cut. That's way above normal for this slice of the calendar year. You have to look back to 2003 to find a comparable result.

As in 2003, the economy is officially out of recession, and the stock market has come roaring back. Again, there are lingering problems. Back then, there were early signs of a housing bubble. Now we're arguably dealing with a sovereign debt bubble. Again, valuations appear too high. In late 2003, the cyclically adjusted P/E ratio on the S&P 500 was around 26. By mid-November of this year, it was approaching 22. These are not the foundations on which sustainable long-term equity returns are built.

A high-quality caveat
It's not that all stocks look expensive. As my colleague Alex Dumortier has repeatedly pointed out this year, there are a lot of good values in the large cap, high-quality realm. I wouldn't lose sleep owning something like Johnson & Johnson or Wal-Mart at these prices, for example. Both have durable franchises, pay solid dividends, and sport very reasonable earnings yields.

What, then, is leading the charge today? Stocks like:

  • Motricity (Nasdaq: MOTR  ) , a "Mobile as a Service" operator that offers a "cloud based infrastructure." Sounds impressive. At seven times sales, this business had better be.
  • Hyperdynamics (AMEX: HDY  ) , an oil company with one large license off the coast of Guinea (which recently saw its borders sealed following post-election violence), no revenue, and no drilling expected until the end of 2011. Market cap? More than $400 million.
  • PharmAthene (AMEX: PIP  ) , a vaccine developer whose potential smallpox payday hinges on the outcome of a courtroom battle with SIGA Technologies.
  • lululemon athletica (Nasdaq: LULU  ) , fitness apparel phenom. The company just reported a blowout quarter, and analysts apparently don't see the potential. I don't, either.

Don't be a knee-jerk jerk
I'm not going to rush off and bet against these stocks just because they're doubled in a matter of months. There are no doubt cases where circumstances have changed dramatically, or where the shares were just previously radically mispriced. It happens. For example, I recently bought a small Israeli company with $0.96 per share in net cash for just $0.54 per share. That stock could double in a short period of time without a whole lot going right.

Instead, I'm going to focus more on building out the short side of my portfolio. I find this especially important, because my portfolio is not full of names like J&J and Wal-Mart. I buy small, weird, ugly little stocks. Many of them hail from speculative sectors like oil & gas and mining. These sorts of holdings tend to get killed when the market turns south. I'm already holding a large percentage of cash today, but I'm thinking I need to crank up the defense further.

Shorting, with baby steps
So far, I've shorted a few individual stocks, including NovaGold Resources (AMEX: NG  ) -- a gold stock with no near-term prospect of going into production. I view this short position as a practical hedge against a soon-to-be gold producer that I own. Now I'm on the hunt for something to protect my downside in the energy realm.

The aforementioned Hyperdynamics might actually fit the bill, since the company won't be drilling anytime soon. That should cut down on any upside surprises that could cause the short position to blow up in my face. I've also got my eye on Houston American Energy (AMEX: HUSA  ) , a Colombia oil story that's been the subject of some convincingly critical reports at Sharesleuth and elsewhere, but my broker doesn't have any shares available to short. Whatever I pick, I'm going to keep these position sizes small, so that no single short moving against me in a big way will wreak havoc on my overall portfolio.

Again, if you're sticking to the highest-quality large-cap stocks trading at modest valuations, you should make it through future turbulence in one piece. If you're like me, though, and you tend to focus on smaller stocks in the more speculative areas of the market, I would suggest that you consider protecting yourself in some way. If you're not comfortable shorting individual stocks -- and I can't blame you, with the risk of losing more than 100% of your money -- then maybe you might want to look at buying a short exchange-traded fund like the ProShares Short Russell 2000 (NYSE: RWM  ) ETF.

I'm very interested to hear what you're doing to protect yourself in this frothy-looking market, or whether you've hit upon a stock that's ripe for shorting. Don't be shy -- share your thoughts in the comments section below.

More interested in finding high-quality companies rather than stocks to short? Here's a special free report detailing five stocks hand-selected by Motley Fool analysts, each of which the Fool has put real money behind.

Wal-Mart Stores is a Motley Fool Inside Value recommendation and a Motley Fool Global Gains choice. Johnson & Johnson is a Motley Fool Income Investor pick. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Johnson & Johnson and Wal-Mart Stores. The Fool has opened a short position on NovaGold Resources. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Toby Shute doesn't have a position in any company mentioned. Check out his CAPS profile or follow his articles using Twitter or RSS. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (27)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 15, 2010, at 12:30 PM, davelfla wrote:

    I'm so glad you are short on HDY. Please report back when the stock is at $4, $5, $6 and let us know how that short position is doing. Do a little research please and try and report even-handedly on the election process in Guinea.

    The first democratic election there has been completed, and after a lengthy process has actually been certified and roundly accepted by the locals and the international community. Yes, the borders were sealed for a couple of days before the Supreme Court rubber stamped the possibly corrupt results. This is Africa and Guinea is more stable now than it is has ever been, except perhaps when under stern dictators.

    HDY is scheduled to drill in less than a year. Along the way there are significant milestones expected that should continue to boost the share price. You are truly "Foolish" to be short at this time.

    Short term it will bob and weave, yes, but the new floor it establishes is always 50 cents higher than the last. Management is sound, confident, and does not over-promise, it just delivers.

  • Report this Comment On December 15, 2010, at 3:22 PM, TMFOpie wrote:

    It's important to keep in mind an Warren Buffett's axiom (backed up by years of experience) that "time is the friend of the wonderful business, the enemy of the mediocre." And these great businesses, which can include some small-cap companies, have stocks that will often rock and roll in the short-term but in the end come out as market-beaters. Trying to time the ups and downs in the markets can often prove to be more churning and burning then is good for our portfolios, rather than finding, studying and buying the great companies that have businesses backed up by managers who can grow our invested dollars over time and healthy returns. And if we're willing to sit through those market waves (as we learned through 2008 and 2009) our portfolios will be better for it.

    Fool on,

    Andy

  • Report this Comment On December 15, 2010, at 4:13 PM, LORENZO176 wrote:

    From the Yahoo Finance site this afternoon, they are advertising a free report from Motley Fool about "the Death of the PC"....I have tried several times to get this report from the MF site, but I keep going round in a circle - it asks for my e-mail address, I give it then it cirlces me back to asking for my e-mail address...................anyone know how I get this report free.....?????

  • Report this Comment On December 15, 2010, at 5:00 PM, TMFAleph1 wrote:

    Hi Toby,

    Thanks for the hat tip in the article. I fully agree with you here.

    I actually just submitted an article in which I suggest that January 2012 puts on the SPDR S&P 500 ETF or the iShares Russell 2000 Index ETF look like cheap insurance for a stock portfolio right now. Combine underpriced volatility with overpriced markets and those puts start to look very attractive!

    As I understand it, your focus is more towards the small-cap spectrum of the market. Small-caps are at least as overpriced as the broad market -- probably more. With both those factors in mind, puts on the iShares Russell 2000 Index are probably a better hedge for your portfolio.

    On the long side, and consistent with the 'high quality' theme, my article goes on to present a basket of calls on 5 high quality stocks that look undervalued.

    Best,

    Alex Dumortier

  • Report this Comment On December 15, 2010, at 6:03 PM, MegaEurope wrote:

    "You have to look back to 2003 to find a comparable result."

    Not 2009?

  • Report this Comment On December 15, 2010, at 6:26 PM, ThriveCounseling wrote:

    Thanks for this post. I've been thinking some of the same things...parts of my portfolio are looking a little too good right now. I have a couple friends I'll need to forward your article too! http://thriveworks.com

  • Report this Comment On December 16, 2010, at 1:10 AM, xetn wrote:

    I think everything is in a bubble except gold, silver and oil.

  • Report this Comment On December 16, 2010, at 8:59 AM, DivingDan wrote:

    JNJ is not a good example of a stock that is not "over heated". They have other problems that are depressing their stock price like the high profile recalls of Tylenol and Motrin.

  • Report this Comment On December 16, 2010, at 9:48 AM, XMFSmashy wrote:

    Hey MegaEurope,

    There was a much larger number of stocks that doubled or more from the 2009 lows, but for the period under consideration -- Aug 31 to Dec 13 -- there were only 54 stocks that fit the bill in 2009. Here are the other years I looked at:

    2008: 1 (it was the apocalypse, after all)

    2007: 32

    2006: 50

    2005: 25

    2004: 54

    2003: 93

    Toby

  • Report this Comment On December 20, 2010, at 4:56 PM, Wade32ru wrote:

    RMW looks like a good hedge for small cap weighted portfolios. Thanks for the idea.

  • Report this Comment On December 21, 2010, at 11:06 AM, davelfla wrote:

    Toby, hope you covered that short on HDY before it jumped almost 20%! Please let us know how that is going.

    The HDY CEO is today attending the (peaceful) inauguration of the new Guinean president. He received a personal invitation to the event from the president.

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