The problem with bubbles is that you don't know when they will pop. A stock can be expensive for a very long time before market participants start getting nervous. Also, high valuation stocks can go much higher than anyone ever imagined. But there is also something else that happens when stocks are overvalued for a very long time: Investors think their valuations are normal.
One such stock is Netflix (NASDAQ:NFLX). Netflix trades at over 400 times earnings and over 100 times forward 12 month earnings. Also noteworthy is that it trades at over 17 times book value.
I have nothing against the company or the company's business model. My beef is with the market propelling stocks like Netflix to the sky for no good reason, and the herd mentality that says nothing is too expensive if it has growth.
Growth is definitely a reason for any stock to trade at a premium, but there are limits to what that premium should be. Currently, the term "growth premium" has no limits attached to it, and the sky is the limit as far as what stocks trade for, or that's what many people think anyway.
In reality, there are limits to everything, but we just don't know where the threshold is. So when extremely expensive stocks correct, they usually do a lot of damage. Netflix is a recent case. The stock has corrected from about $390 several days ago to as low as $311 today.
And why did Netflix correct you might ask? Guess what, not because the herd thought it was a bubble, but because Carl Icahn posted on Twitter that he sold about 50% of his position after the SEC filling.
You can try to trade the bounce in Netflix, but do not think for a moment that this is a cheap stock, or that it cannot fall a whole lot more from current levels.
Tesla (NASDAQ:TSLA) is another extremely expensive stock that has been in the limelight for a while now. For some reason investors think that a forward PE of 92, a P/B ratio of 31 and a Price/Sales ratio of 15 are normal for stocks with above average growth potential.
I am sorry but it is not. There are limits to how far in the future investors should discount future earnings and sales growth and Tesla (among others) have exceeded those limits.
And just as with Netflix, the market all of a sudden knocked down Tesla by about 20% and many investors are trying to figure out why. The reason is that it's a very expensive stock.
Netflix and Tesla are not the only stocks that are grossly overvalued. There are many other stocks out there that also trade at insane valuations that have not corrected one bit.
One of the reasons for this resiliency has to do with Fed support. Another probably has to do with the fact that we have not seen a major market correction for a while now, and also that the market is breaking new records almost on a daily basis.
Investors should keep away from many high flying, high valuation stocks, because a 20% - 30% correction might actually be the best you will be hit with. There are stocks out there that will correct a whole lot more if we see a major market correction one of these days.
All of these stocks trade at extremely high P/E, P/B and Price/Sales multiples that are not -- in my opinion -- deserved, even if these stocks are exhibiting above average growth.
So be on the lookout if you have a very high grossly overvalued stock in your portfolio, because the first ones to correct are the big boys, and the smaller less talked about stocks, usually follow.