Should You Take Profits In This Market?

Earlier in the year, when the market was feeling a bit frothy, I remember secretly hoping for a mild correction. Not a stomach-churning freefall, mind you, but an orderly 10% pullback to wring out excessive valuations and unearth some bargains.

We got a pullback all right. But it was far deeper and more volatile than I would have liked. And that’s an understatement. On February 20, the S&P 500 opened at 3,380. On March 20, it closed at 2,304. That’s a jarring decline of more than 30% — in just one month.

Be careful what you wish for.

Flash forward to today, and the index has recouped all of those losses and then some. Several days ago, it touched a record high of 3,588. So if the market appeared overvalued back in February, then stock prices are even more stretched now – particularly when measured against earnings, which plunged 34% last quarter.

The S&P was recently trading at a rich 27 times forward earnings – the steepest valuation since 2001.

Of course, the market is a forward-looking mechanism. Investors are pinning their hopes on a strong recovery in 2021, buoyed in part by an accommodative Fed, a potential vaccine, and trillions in Federal stimulus spending.

My position has been (and remains) that the market retreat and subsequent advance both went too far – we overshot to the downside as well as the upside. I still believe the resilient economy will recover quicker than many believe. And analysts are indeed forecasting a healthy 24.8% bounce in S&P earnings in 2021.

Still, this rally has gotten ahead of itself, particularly with market leaders that have been driving this charge.

Take a look at Zoom Video (Nasdaq: ZM), for example.

The stock rocketed from $325 to $450 per share on September 1. We’re talking about one trading session. What are the shares worth? Well, without getting too nuanced, I can say that Morningstar has determined a fair value of $153. That calculation involves an educated forecast of the company’s future cash flows discounted back into today’s dollars. It also takes into account other key factors such as the weighted average cost of capital.

If Morningstar is right, the stock could fall by half and still be overvalued.

I don’t mean to pick on Zoom. It’s an innovative company with brisk macro tailwinds and explosive growth potential. Still, it’s hard to argue the business is worth more than $100 billion – the GDP of Puerto Rico.

The Takeaway

It’s hard to make money by paying $450 for a stock worth $150. Sure, you can always hope there’s a bigger sucker that will pay $500 a few weeks later. And often, there is. But like a house of cards, sooner or later it all comes crashing down.

The market has clearly been letting off some steam for the past week, and it wouldn’t surprise me to see more declines ahead. We are overdue for profit-taking, plain and simple.

Not that I believe in superstitions, but September is also historically a bad month for investors. We are true to form thus far.

Dare I wish for another pullback? Probably not. But we may get one just the same. In any case, if you find yourself in the same position as my premium readers and me – sitting on some nice, large returns as a result of this rebound – then you may want to close out a couple of positions.

The good news is that there are still opportunities in this market. You just need to know where to find them…

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