In the short term, the stock market is a popularity contest. A high-performing stock gets the most coverage, and people begin buying shares simply because its price has been going up. This drives the price even higher, drawing more people into the stock. This can only go on for so long -- eventually, there aren't any buyers left. A horrific crash follows, leaving those who bought in late with staggering losses.
There's no telling how long it will take for this crash to occur. Often, even the smallest piece of bad news can trigger it. Let's take a look at a few stocks which have risen too far, too fast -- and might be set for a painful fall.
Electric car maker Tesla (NASDAQ: TSLA ) has been on a tremendous run so far this year. The stock has shot up like a rocket, with the company now valued at about $23 billion.
But there's a big problem. Tesla sells around 5,000 cars per quarter. Although this number is rising, it's a tiny fraction of the hundred of thousands of cars which General Motors sells every month. Yet Tesla's market capitalization is a little less than half of GM's and about a third of Ford's.
Let's imagine that it takes Tesla 10 years to reach Ford's market capitalization. From the beginning of this year, here's what an investor's annualized rate of return would be over the next decade, based on the date of purchase:
At the beginning of the year, with Tesla shares in the $30s, an investor could have achieved an annualized return of 30% in this extremely optimistic scenario. But now, that expected return has dropped to about 12%. In other words, absolutely everything has to go right for the next decade for Tesla investors buying today to achieve slightly better-than-average returns.
This scenario relies on Tesla putting out a mass-market car, which the company plans to do in 2015 at the earliest. It also relies on the company's ability to sell hundreds of thousands, possibly millions, of these cars by 2023. In an extremely capital-intensive industry, ramping production by that magnitude will be an extremely expensive and profitless endeavor. By that time, the big car companies will certainly have cheap electric vehicles on the market.
Investors buying Tesla today are playing a dangerous game. The stock is outrageously overpriced, and it will eventually come crashing down.
All the rage
3D printing is apparently the next big thing. Shares of companies that make the 3D printers, like 3D Systems (NYSE: DDD ) , have risen dramatically over the past few years.
A 3D printer creates three-dimensional objects out of special material. It's an interesting technology, but there's no reason to believe that factories will someday be full of the devices. Mass production will always be cheaper and faster -- there's simply no way for 3D printers to compete on that front. It's much like a home inkjet printer vs. a giant commercial printer. For big printing jobs, the efficiency of the commercial printer more than makes up for the larger capital cost . And, honestly, the world doesn't need more plastic junk.
3D Systems trades at 140 times earnings and 16 times sales. Apparently, the market believes that consumers will all have their own 3D printers at home someday. I seriously doubt that.
Not like the others
Retailer Costco (NASDAQ: COST ) is not in a bubble like Tesla and 3D Systems above. It's one of the only retailers that has been able to continually report rising sales and profits. Both Wal-Mart and Target came up short of expectations last quarter, and other retailers are also struggling. But Costco just keeps on growing, beating expectations along the way.
This has caused people to flock to the stock. Costco trades at nearly 30 times last year's earnings and 25 times trailing earnings. While the company is growing fast, it has become big enough that its earnings likely won't grow fast enough to justify this valuation. Costco is viewed as best-of-breed, and it is, but often these types of stocks get expensive when everything is going right. The best time to buy Costco will be when things start to go wrong, and investors begin to flee.
The bottom line
Popular stocks are almost always overvalued, and some can even enter a bubble-like state. Tesla and 3D Systems are trading at levels which don't make any sense, and eventually this will be corrected. Costco, while certainly not in a bubble, is still too expensive thanks to the constant stream of good news. The higher the price you pay, the lower your return. It's as simple as that.