There's only one thing better than finding a stock that gives you outstanding returns: turning your paper profits into cold, hard cash before the bottom falls out of the market.
One day certainly won't single-handedly turn one of the strongest rallies in stock market history into the next wave of the bear market. But anytime you see a major pullback in stocks -- like you did on Monday -- you'll start wondering whether it's time to take some money off of the table.
Still, the big question is what you should sell. In a nutshell, the answer is simple: Sell stocks that have gotten overvalued in the most recent rally. How, though, can you tell which stocks those are?
Bullish beyond belief
The interesting thing about the rally is just how indiscriminate it has been. Good companies and bad alike have seen their share prices lofted into the stratosphere. Many of the stocks that got hit the hardest, including Ford Motor (NYSE: F), Sirius XM Radio (Nasdaq: SIRI), and Wells Fargo (NYSE: WFC), have seen their shares triple or more in value. In some cases, those moves were justified by the fact that they got beaten down so far.
Yet other companies that haven't seen such big moves still look pricey. Many companies not only have inferior reputations based on the opinions of members of our Motley Fool CAPS community, but they also sport valuations that no longer make sense given their modest growth prospects. Check out this sample:
| Stock | CAPS Rating | 6-Month Return | Forward P/E | 5-Year Forward Growth Estimate |
|---|---|---|---|---|
| Wynn Resorts (Nasdaq: WYNN) | * | 119.5% | 72.7 | 7.8% |
| Masco (NYSE: MAS) | ** | 126.5% | 39.0 | 12% |
| Monster Worldwide | ** | 87.0% | 119.8 | 20.4% |
| Ryder System | ** | 34.7% | 18.6 | 1.6% |
| Marriott (NYSE: MAR) | * | 56.5% | 28.2 | 3.8% |
| MeadWestVaco | ** | 106.9% | 31.0 | 10% |
| Robert Half | ** | 57.0% | 71.6 | 12.7% |
Source: Yahoo! Finance, Motley Fool CAPS.
What's holding these stocks up? Clearly, many investors expect the eventual economic recovery to create profits for these companies. But even if analysts' expectations prove to be correct -- something you always have to watch out for, given the potential bias toward overestimating future growth -- that growth won't justify the big jump in valuations that these stocks have seen.
But they're still cheap!
Of course, when you look at these stocks over a longer time horizon, you might not think they're so overvalued. Look what happens when you expand that look back from six months to a year:
| Stock | 1-Year Return |
|---|---|
| Wynn Resorts | (47.3%) |
| Masco | (22.5%) |
| Monster Worldwide | (27.6%) |
| Ryder System | (43.2%) |
| Marriott | (17.1%) |
| MeadWestVaco | (17.3%) |
| Robert Half | (0.7%) |
Source: Yahoo! Finance.
Contrary to stocks like Green Mountain Coffee Roasters (Nasdaq: GMCR) and Shanda Interactive, which have been on a tear for years, all of the above stocks are net losers over the past year. Undoubtedly, many investors are still sitting on significant losses from these stocks, hoping that if they can just wait for the stock to rise enough to give them a small profit, then they'll happily sell. They just don't want to take a loss.
That line of thinking, though, will get you in trouble. Fixating on a particular price is a phenomenon known as anchoring, and it's almost entirely irrational -- the shares will move independently from the price at which you bought them, so there's no reason to assign any particular significance to that price. If you're fortunate enough to see your shares rise substantially, it's an opportunity you may need to jump on -- even if it means selling at a loss.
It isn't different this time
Unfortunately, not every stock will recover all of its losses. Even once the economy recovers, some companies may find that their own particular businesses won't follow suit. Just as dozens of Internet companies never emerged from the tech bust, we've already seen many companies fall prey to the financial crisis -- and even the survivors will have to deal with the effects of the crisis for years to come.
Under normal circumstances, finding stocks that you can buy and hold for the long term makes things simpler for investors. Yet as volatile as the markets have been lately, overvalued stocks create profitable opportunities to sell. Take a close look at your stocks and see if you think they justify their current valuations. If not, you can find better places to put your money.
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