101 Reasons the Market Looks Overheated Today

Now looks like a great time to play defense.

Toby Shute
Toby Shute
Dec 15, 2010 at 12:00AM

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.

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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.

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