The markets continue to show unrelenting strength, with the broader market trending higher at record levels of the last week. As to be expected, with the broader market at record highs, a lot of big name stocks have enjoyed massive gains, and could be in danger of rapid profit taking should the bears sweep in and begin pulling money off the table.
It is human nature to look at stock charts that have trended sharply higher and want to jump in with the hopes of additional future appreciation. The problem is that by the time stocks have made strong moves higher, it becomes more likely that the smart money has already moved into the stock, and the upside has become limited.
You never want to follow the herd into a position, but at the same time, it would be foolish to universally ignore every stock that has shown recent strength. Reason being that stocks tend to move in one direction or the other for a good reason. There are usually very good reasons why weak stocks are moving lower, as well as good reasons why the market has been bullish on strong stocks.
The real question becomes whether or not the market overreacted and drove the stock into overbought territory. For current shareholders, this would be a signal to lock in some profits, and for potential investors it would indicate that the upside has been exhausted in the stock, and they should look for better value elsewhere.
When looking at valuations, the market uses a company’s price-to-earnings ratio as a measure of value. A general rule of thumb is that a stock is fairly priced when it trades with a P/E in a range of 15 to 25. Of course, there is no universal rule on judging valuation. You have to not only consider a stock’s current valuation, but also take into consideration the company’s forecast earnings growth. The stronger a company is expected to grow earnings the higher the market will allow the stock’s valuation to rise before considering it overbought since future growth will bring the ratios back in-line.
Let’s take a look at five stocks that have high P/E ratios, and consider whether or not the stocks appear to be good buys at current levels.