It's increasingly clear that it's the beginning of the end of the recent market rally. The major indexes have moved steadily higher since Oct. 1, 2011, with some of the more speculative stocks becoming the biggest gainers. These stocks weren't cheap to begin with, so now they're really quite pricey.
In the weeks and months ahead, the market may still trend higher, but investors will likely take an increasingly defensive posture, gravitating toward more reasonably-priced stocks. For the market's biggest recent winners, trouble could be ahead.
I went looking for stocks that have a price/earnings to growth (PEG) ratio above 1.0, which means that the P/E ratio on projected 2013 profits is even higher than the projected earnings growth rate. Every one of these stocks has risen at least 30% since Oct. 1, trades for at least 35 times projected 2013 profits and sports a PEG ratio above 1.0. (In some instances, 2012 profits will likely be negative, making a PEG ratio hard to calculate.)
Some of these stocks were heavily shorted to begin with, and short covering simply pushed them much higher. Other stocks have delivered solid quarterly results, encouraging investors to embrace high-growth (but also high P/E) stocks. Yet with the U.S. economy still looking just OK (recent economic reports have been a bit more sobering), investors may soon shift gears and start avoiding the highest P/E stocks.
Also in the tech realm, you'll find cloud-computing stocks Rackspace Holdings (NYSE: RAX) and InterNAP (Nasdaq: INAP) -- companies that offer outsourced server management capabilities. Analysts at Dougherty & Co say Rackspace has moved into overvalued territory. The company is expected to post an impressive 30% jump in sales this year to $1.3 billion compared with 2011, and another 25% in 2013 to roughly $1.65 billion. They figure this high-growth platform is worth a pretty robust 10 times projected 2012 EBITDA. They even concede that another company may acquire Rackspace, so they use a multiple of 12, which is pretty high, to determine their price target, and this equates to a share price of $40. Shares have already shot past this mark, however, and are in the low $50s.
Perhaps the most overvalued name in this group is online vitamin distributor Vitacost.com (Nasdaq: VITC). The company struggled out of the gate after completing a late 2009 IPO, eventually needing to replace its management team. Even as sales rose steadily throughout 2010, a series of snafus led to operational inefficiencies, pushing EBITDA into negative territory.
CEO Jeffery Horowitz took the reins in the summer of 2010 and has been slowly working the kinks out of the company's business model (though it has yet to post an operating profit). The company will release fourth-quarter results on March 15, and it's likely to report incremental progress on its march back to profitability. Analysts say the company may finally turn a profit by the second or third quarter of 2012, and full-year profits by 2013.
Even so, the stock seems to have gotten ahead of itself. It trades at roughly 35 times projected 2013 profits, which is more than twice the multiple sported by vitamin-selling rival GNC (NYSE: GNC). The vitamin business is largely mature, so hopes that Vitacost can "grow its way into the multiple" in 2014 and beyond appear misplaced.
Risks to Consider: If the market keeps chugging even higher, then investors may "let these winners ride," making them too risky to short.
Action to Take --> The market is changing, and what has worked in recent months is unlikely to keep working in the months ahead. This means you should be harvesting profits on these now-pricey stocks if you own any of them. Those who are feeling somewhat bold might want to look into shorting some of the stocks I've mentioned.
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StreetAuthority LLC does not hold positions in any securities mentioned in this article.