Abundance of Extended Stocks Suggests Caution

by: Alan Brochstein, CFA

The recent rally in stocks has left the market in a disturbing position for me. On the one hand, as I shared last week, I am optimistic about 2011, projecting a rally to 1500 on the S&P 500. On the other hand, there are many signs that we are overbought, and I fear that the next several weeks could see some retracement.

This is the time of year when I always caution investors to be careful about some of their more successful investments. The desire of institutions to show "winners" and of individuals (and their managers) to postpone taxes leaves a void of sellers of stocks with very high returns. This is only part of my concern.

A secondary concern is that many stocks and even the broad market are "overbought". There are many ways to define this condition - I use one that takes into account the volatility of a stock (or index) and its price deviation from a moving average. I tend to use this metric for stocks, and not the market, but it can be helpful for understanding the trend in stocks broadly. Currently, we are less than 1 s.d. above trend. To me, this suggests potential consolidation and not a reason for grave concern. I have found over the past two market cycles that buying oversold makes more sense than selling overbought.

More troubling, I have a proprietary metric I use that gives me pause. By proprietary, I don't mean a big secret - I just guarantee almost no one else in the world uses it, but it has been very helpful to me over the years. It doesn't even have a name, but allow me to describe it. I rank stocks using numbers and colors to determine their technical trend. I use a short-term (10 days), medium-term (50 days) and long-term (150 days) moving average to determine the score (from 1 to 5, where 1 is good). I also use green and red to indicate the change and black to highlight a period of no change (13 weeks). I monitor these numbers weekly for my 100-stock Watchlist.

As you can imagine, I have a lot of "green 1s" - stocks that have seen their 10dma cross their 50dma which is above their 150dma. The problem is that many have turned black, in fact 16% of the list is like that. My theory of mean-reversion, that the stock has to at least move back to its 50dma, is grounded in logic. It isn't sustainable that a stock (or a market) always rises (or falls). When I am looking for new names, I love to focus on a "black 5" for possible entry. I have only one out of my 100 stocks that falls into that category at this time.

With these thoughts in mind, I wanted to share a list of stocks that might be particularly vulnerable in coming days. I started off by restricting my analysis to companies with market capitalizations of greater than $500mm in the Russell 3000. This left almost 2000 names. I then removed all names up less than 50% YTD, leaving 418 names. Wow! Lots of great stocks in 2010.

So, how do we narrow this list to identify possible retracement ahead? I tried to strip out truly fundamentally improving stories by applying an earnings revision metric (EPS revisions for next year < 20%). I also looked at two-year returns to make sure that the stock wasn't just bouncing back from a bad 2009 (>100% over two years). I also put a valuation metric on to look for things that might be expensive (Forward PE > 1.4X 5yr average). Finally, I pulled out names that were more than 10% below the 52-week high. Here are the 36 names that made the cut (note that I pulled two companies being acquired and may have missed others). Click to enlarge:


I sorted the list by economic sector and then YTD returns. As you can see, 6 of the 10 sectors are represented. I also included the last column, which is what analysts expect in terms of EPS growth 2 years out. Note that many of these companies are expected to have strong growth in 2012 and may not be unjustified in their price. One that I follow closely, Stratasys (NASDAQ:SSYS), has a big deal with Hewlett-Packard (NYSE:HPQ) that could really kick in. I mention this because this list is only a starting point and not a conclusion. With that said, let's pick on one stock on the list that may be a great example: Neogen (NASDAQ:NEOG)

NEOG, which was helped by the egg safety issue earlier this year, has been a "black 5" since September, as the moving averages crossed in June. Yes, the 10dma hasn't dipped below the 50dma since June. According to my price momentum indicator, it is 1.72 units overbought, which is quite extreme. Interestingly, the stock isn't heavily shorted. The stock is "expensive" - 41PE. I think that this is a good example of a company that could run into some profit-taking.

What have I done about this short-term challenge? I have totally repositioned my Top 20 Model Portfolio over the past few months, leaving subscribers with very little exposure to overbought or particularly extended stocks. The model is up 49.6% YTD, but our weighted-average YTD return on the current holdings is actually -4.5%. The median return is close to zero - we have successfully rotated the portfolio, locking in gains early in the year and then recently. I shared the model and its 20 holdings at the beginning of the year. We currently hold just 3 of those names. I will be sharing my model again for the third consecutive year in two weeks.

As 2010 comes to an end, I recommend checking your portfolio for names that could be subject to correction or at least be prepared for a potential set-back. Many stocks are extended. The market in general, though, isn't particularly extended. Using my own metric, it will remain a "green 1" until late January (assuming it doesn't pull back before). Having the moving averages cross isn't necessarily going to be particularly challenging for the market - it could happen with a very shallow retracement . The bottom-line: Don't chase right now, as opportunities will most likely present themselves in coming weeks.