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Prep for the Pullback Now

Sure, we all feel like geniuses now, right? We stuck it out -- "it" being the worst economic crisis since the Great Depression -- and have now enjoyed fat and happy double-digit gains ever since the market hit bottom in March.

There's surely more to come, right? Right?!

Survey says ...
Who knows? We Fools pride ourselves not on making market calls, which are a great way to get slapped silly by the market's invisible hand. Instead, we take pride in our fundamental focus. Is a company's market share likely to shrink or grow? Has its management team delivered the goods over the long haul while deftly navigating both up markets and down? And in terms of valuation, does the firm's stock look like a blue-light special or a high-end luxury item?

In my experience, that last element -- valuation -- is often the toughest taco to crack. Some companies never look cheap, after all. Others that appear to be bargains may turn out to be value traps instead. Still, in general terms, one thing remains true: When a company sports moon-shot multiples, there's little opportunity to cushion the blow when the overall market hits the skids or when the company itself blows up.

The higher they fly, the harder they fall
For example, take Research In Motion and Google (Nasdaq: GOOG  ) . The former has gained 62% since the market's nadir, even after factoring in its recent rocky performance. The latter has increased by roughly 76% over that same stretch -- heady gains that ought to be understood in historical context.

Back in June 2008 -- shortly after reaching a fat and unhappy P/E above 60 -- RIMM began a precipitous slide that saw the company's shares shed over 50% of their value. Google suffered a similar fate when its above-40 P/E bubble burst around the same time. 

Could investors have seen that coming? Not with perfect clarity, of course, but if they'd tuned into each firm's valuation, savvy investors might have dodged a bullet by taking gains, waiting for valuation gravity to work its magic.

Both companies have recovered since their respective sell-offs, and while each currently trades with far more modest multiples -- they're not quite modest enough for my taste: As the history lesson I've just sketched illustrates, a little valuation discipline can go a long way. When an all-but-inevitable market pullback arrives, highfliers can be sitting ducks -- and future bargains, at least in relative terms.

Good companies. Lousy investments?
Along those same lines -- and following big run-ups over the last 12 months -- (Nasdaq: AMZN  ) and Apple (Nasdaq: APPL  ) could be cruising for proverbial bruising, too. That goes double for Visa (NYSE: V  ) , with a current P/E hovering above 26 despite the firm's deep sensitivity to consumer spending patterns and financial health during tough economic times. 

Last but not least: (NYSE: CRM  ) , which is currently priced at more than 77 times analysts' earnings estimates for fiscal year 2010. Given the eternal -- and generally erroneous -- optimism of Wall Street's Gucci-loafer set -- not to mention the weakness of the business spending the company relies on -- that's way too rich for my blood.

That's particularly true, moreover, when there are plenty of long-haul overachievers trading on the cheap. Cases in point: Johnson & Johnson (NYSE: JNJ  ) and Hewlett-Packard (NYSE: HPQ  ) , both of which sport P/E's below the S&P's and their own five-year averages to boot.

The Foolish bottom line
There's more to uncovering values than just parsing price multiples. Separating truly cheap stocks from merely cheap-looking ones is a full-time job.

If you'd like some assistance when it comes to avoiding value traps, be sure to check out the Fool's Inside Value service, where the emphasis is squarely on rock-solid companies trading for a song. Click here to take the service for a completely free 30-day test drive.

This article was first published June 2, 2009. It has been updated.

Shannon Zimmerman runs point on the Fool's Ready Made Millionaire and Duke Street services and doesn't own shares of any of the companies mentioned in this article. and Google are Motley Fool Rule Breakers recommendations. Apple and are  Stock Advisor picks. Johnson & Johnson is an Income Investor pick. The Fool has a strict disclosure policy.

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