By Michael Vodicka
In the past month, the market has been confronted with a bearish run of data warning of weakness in the economy.
March's nonfarm payrolls jobs report was a big disappointment, with 88,000 new jobs falling well short of expectations of 200,000. Manufacturing is slowing, with the ISM manufacturing index falling to 51 in March. That's down from 54 the previous month and dangerously close to 50, which would signal a contraction.
Consumer confidence is falling as well, with the Thomson Reuters/University of Michigan consumer sentiment index from mid-April dropping to a nine-month low that is associated with recessionary levels.
That fundamental weakness is also beginning to show up on charts. Last week, on StreetAuthority
I wrote about the emergence of the Hindenburg Omen -- one of the most bearish signals for the S&P 500 -- flashing red for the first time in almost three years.
This pattern of weakness emerging in the economy right now is the same seasonal weakness that has occurred in each of the past three years, where great starts to the year have been foiled by a big swoon in May and June. Take a look:
These are all signals of a potential correction for stocks. But while that is a threat to the entire S&P 500, it is an even bigger threat to the most overvalued stocks. Not only will these stocks be the first to fall, but they are also in danger of falling more than their peers.
There are two main reasons for this.
1. Overvalued stocks have frequently experienced a string of outsized short-term gains in which investor enthusiasm pushes shares temporarily into overbought territory. That can lead to a wave of profit-taking from short-term traders and investors looking to lock in quick gains.
2. Overvalued stocks are at risk because they simply don't have the earnings power to sustain their upward trajectory. On a long-term basis, a stock's valuation will always return to its long-term average, making the higher valuation an unsustainable aberration.
That's why it's so important for investors to keep tabs on the valuation of the stocks in their portfolio. Here is a list of the seven most overvalued stocks in the S&P 500, making them particularly vulnerable to weakness in the market and economy.
From the list, I have chosen to highlight Amazon
) because its 2013 earnings estimate has fallen 17% in the past 90 days and Range Resources
) because of potential weakness in natural gas prices after a surge of 35% in just the past four months.
Amazon has been a highflier in the past 12 months, posting an outsized 37% gain. But that upward momentum has pushed shares of Amazon to nosebleed levels, with a forward price-to-earnings (P/E) ratio of 187, a huge premium to its peer average of 22.
There's no doubt that sky-high valuation is unsustainable and weakness in the economy and market could be the catalyst to revert valuation back to the long-term average. On a longer-term basis, analysts are looking for annual earnings growth of 29% in the next five years -- but as you can see from Amazon's valuation, all of that growth and then some is already priced into shares.
Range Resources has also had a great year, with shares up a market-beating 22%. Those gains for the natural-gas explorer have been fueled by surging natural gas prices, up an even more impressive 32% on the year.
That has lifted Range Resources to a sky-high forward P/E ratio of 61, more than three times its peer average of 20. Summer is also a seasonally weak time of the year for natural gas consumption, fueling concern that prices could slip lower in the next few months as companies expand production to capitalize on higher prices in the face of slowing demand.
Risks to Consider: Momentum stocks have been notorious for trading with high P/E ratios for extended periods of time and defying value investors' call for a correction. Although the valuation of these stocks doesn't look sustainable, momentum has been the bane of many value investors.
Action to Take: The economy and S&P 500 are both showing signs of weakness. While that is a threat to all stocks, it's an even bigger threat to stocks with sky-high valuations. These are the seven most overvalued stocks in the S&P 500, making them particularly vulnerable to weakness in the market. From the group, Amazon is vulnerable because its 2013 earnings estimate has fallen 17% in the past 90 days and Range Resources is vulnerable because of potential weakness in natural gas prices after surging 35% in just the past four months.
Michael Vodicka does not personally hold positions in any securities mentioned in this article.
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