Wondering What to Buy? Then Ask What to Sell

The Dow Jones Industrial Average is within striking range of the magic 10,000 milestone and the Nasdaq Composite is less than 100 points from the next Common Sense selling target, which is 2220. The Nasdaq is closing in on its third consecutive selling threshold, which is 75% above the low hit on March 9. Only once since I started writing this column in 2000 have there been three such selling opportunities without an intervening correction.

The latest impetus has been a flurry of mergers-and-acquisitions deals, successful initial public offerings, and attendant hopes that the private-equity pipeline will flow again, adding liquidity and driving up equity prices across the board. Add to that mainstream pessimism about stocks’ chances to go much higher—exactly the kind of thing that drives contrarian investors to buy—and you have all the elements for a sustained rally.

Of course, it’s always easier to explain the market’s moves than it is to predict them. All I can say is that the longer the rally continues without a correction, the more likely a correction becomes. That’s why I steadfastly adhere to my disciplined approach to buying and selling, which calls for taking profits at intervals of 25% gains in the Nasdaq, and buying on 10% declines. The goal is to buy lower and sell higher, and if this means being a little early, it’s a nice problem to have.

As has always been the case in a sustained rally, I’ve been getting more and more questions from readers about what to buy now. To me, that’s the wrong question. Investors should be asking what to sell. But in a sense, both questions are opposite sides of the same coin. Something investors should be selling is, by definition, not something anyone should want to buy. Or is it?

To test this notion, I revisited the list of overvalued stocks I put together at the last selling opportunity, which was less than two months ago. In my column of Aug. 11 I identified 10 stocks with both strong momentum and high price-to-earnings-growth (PEG) ratios on the theory that they were most vulnerable in a correction. But this turned out to be a correction that hasn’t come, at least not yet. I was curious to see how overvalued stocks performed in an ongoing rally.

Pretty well, it turns out. Over the same period (Aug. 11 to Sept. 28), the S&P 500 gained 6.9% and the Nasdaq 8.2%. Eight of the 10 overvalued stocks outperformed both, in some cases by a wide margin. None of the stocks declined, with the weakest gaining 4.3%.

Tenet Healthcare (THC), which seems unfazed by all the talk of health-care reform, gained a remarkable 40%. At nearly $6 a share, it’s not far off its high for the year and has gained sevenfold since its low.

Powerwave Technologies (PWAV), which makes wireless communications equipment, was another top performer, up 32%. It’s up sevenfold since hitting a 52-week low of 23 cents a share in March. Still, it’s a highly volatile stock that’s still less than half its 52-week high of $3.96. Both Tenet and Powerwave maintain highly elevated PEG ratios of 10.0 and 11.3, respectively. (For the PEG ratios I used Bloomberg, which calculates the number using estimated operating earnings for a period of three to five years.)

Indeed, the companies with the highest PEG ratios also did well. Semiconductor maker LSI (LSI) now boasts a PEG ratio of 92.6, yet gained over 15%. Despite declining business travel, Starwood Hotels & Resorts (HOT) gained over 14% and now has a PEG ratio of 55.5. And even though art collectors have been lying low, auctioneer Sotheby’s (BID) rose nearly 10% and has a PEG ratio of 47.7. Perhaps traders know something I don’t, but these are extremely high valuations.

Conversely, the worst-performing stock, super-computer maker Cray (CRAY), has one of the lower PEG ratios of the group, at 5.3. (By comparison, the average PEG ratio for the Nasdaq is 1.8.)

So the lesson of this rally seems to be that the strong are likely to get stronger, which is very much the hallmark of a momentum-driven rally. If you think this rally will continue, and want to buy now, this evidence suggests you should look for stocks that have already done well and appear to be overvalued. While it flies in the face of value-driven logic, these stocks could very well be the best performers in the last gasp of a rally.

To me, this is the logic of the hard-core trader and momentum investor. It not only depends on the rally continuing, but assumes investors will know when it’s over, and it’s time to get out. So far as I know, no one has perfected a system that can provide such perfect timing.

As I’ve said before, no rally goes on forever. The tide will turn, and when it does, I suspect the overvalued stocks will be the hardest to fall. That’s why I’ll continue to prune my exposure to the highest-flying stocks when and if we hit another selling threshold. Cash may seem dull today, but remember what it felt like just a year ago?

These high-priced stocks also make excellent gift-giving candidates. Many people like to wait until December to give appreciated stocks to charity, but there’s no better time than a selling threshold. And you can be assured that cash-strapped institutions will be happy to receive your gift a few months early.