3 Stocks at Risk, and 4 That Are Protected

While the market's bulls continue to whoop it up, they're ignoring a critical factor hanging over their heads, threatening stock prices. Indeed, with corporate profitability near record highs, stocks are vulnerable to a reversal of the upward trend we've witnessed since the trough of the Great Recession. What's the market worth on the basis of "normal" profits?

Here, I'll answer that question, then identify three individual stocks that look particularly vulnerable to a correction, and four that look well protected.  

How do profits relate to stock market valuation?
Typically, Wall Street values stocks at some multiple of current or forward earnings. If the market expects a stock to generate $x over the coming year, it capitalizes those $x at a P/E multiple that reflects investors' assessment of future earnings growth and risk.

The exact same thing is true of the broad market. If we use the S&P 500 as a benchmark for the U.S. stocks, we get:

S&P 500 Index Value = (S&P 500 P/E Multiple) * (S&P 500 Earnings per Share)

In other words, current (or one-year forward) earnings are one of the two fundamental building blocks of the market's valuation.

Are profits high right now?
The S&P 500's earnings margin over the trailing 12 months is 8.4%. During the last decade, this figure was higher from mid-2004 through the the third quarter of 2007 -- a period that coincides with a massive bubble in corporate profits, created both by phantom securitization profits in the financial sector and consumer spending boosted by unrealized housing-wealth steroids.

What are the implications of above-normal profits?
Because Standard & Poor's revenue per share data only goes back to the beginning of 2000, the profit margin series for the index is too short to be meaningful. Instead, I looked at a broader measure of profitability. The following graph shows the national economy's profit margin, measured by after-tax corporate profits divided by gross domestic product (GDP):

Source: Bureau of Economic Analysis and Standard & Poor's.

The blue line represents the profit margin for the national economy. The red line is the series average over the entire period (6%). Finally, the two dotted lines display represent the average value plus or minus two standard deviations -- a statistical measure of how much or little a data series varies from its average.

Note that periods in which the profit margin exceeds its average alternate with periods in which it drops below that figure. This is known as mean-reversion – a property observable across a number of economic and financial variables. Basically, in the long run, the market may swing high or low, but it'll always turn back towards its average eventually.

The graph shows that corporate profitability is near an all-time high, and well above the long-term average. Look out below!

Assuming profits are closer to the historical norm, what's the market worth?
At a "normal" profit margin of 6% instead of 8.4%, operating earnings for the 12 months ended Sept. 30, 2010 would have been $56.51. That's 28% less than the actual earnings of $79.00. Applying that discount to the S&P 500's current value of 1,332.87, we get an estimated fair value of roughly 950.

Admittedly, this is a pretty crude approach to valuing the market. Still, it's more robust than using a one-year forward earnings estimate balanced precariously on the crest of the massive recovery in corporate profits. Don't look at this surge for guidance -- after all, the wave could be just about the break.

What about individual stocks?
In the context of this analysis, it should be clear that the overall market is vulnerable to a correction. But what about individual stocks? The same principles apply: All other things equal, companies with current profitability well above their historical average could experience a dramatic slowdown in profit growth -- or even a profit decline! In addition, this could bring down the multiple that investors are willing to award the stock.

In order to identify the stocks that are most vulnerable to this process, I ranked every company in the S&P 500 on the basis of how their current profit margin compares to the measure's historical range, then repeated the process using the P/E ratio. 

The first three stocks in the table below belong to the group of stocks in which both figures occupy the top of their historical range; I label them "vulnerable stocks." Conversely, the next four stocks have a net income margin and P/E at the bottom of their historical range, which means they might be better protected if the economy slows down or the market corrects. If anything, the market might increase their value.

*Price/trailing-12-month normalized net income. Source: Capital IQ, a division of Standard & Poor's.

You can track both the vulnerable stocks and the protected stocks using My Watchlist. By doing so, you'll get valuable updates on their progress, as well as immediate access to a new special report, "Six Stocks to Watch from David and Tom Gardner." Click here to get started.