These Stocks Look Ripe for a Pullback

As the market has crawled ever higher during the past three years, a clear theme has emerged: When the market slumps, investor pessimism gets carried to extremes; and when the market posts a strong rally, things are not as solid as they appear.

#-ad_banner-#Indeed, that’s where I think we are right now. The markets are in the midst of another strong run, though considerable challenges remain. Sure, we’ve seen a slew of positive economic reports in recent days, but the U.S. economy is far from healthy. Perhaps of greater concern: companies are reporting that sales are rising faster than profits, a sure sign that profit margins are slipping back. So if the U.S. grows in the 2-3% range in 2012, as most economists anticipate, then investors need to brace for slowing sales and perhaps falling profits in the quarters ahead.

That’s not an argument to dump all of your stocks, but it surely calls for portfolio pruning. Harvesting winners and raising cash levels may be the best approach for the current market. Simply put, any stock that has risen by a considerable amount in recent months needs to be closely scrutinized to see if it has maxed out and is primed for a pullback. Some of these fast-rising stocks may be ripe for short-selling because their valuations now outstrip the reality on the ground.

The 24 stocks you’ll see below have risen at least 30% in the past 13 weeks, and all trade for at least 25 times forward earnings estimates.

The list is filled with an unusual group: housing stocks. KB Home (NYSE: KBH), Toll Brothers (NYSE: TOL) and MDC Holdings (NYE: MDC) are all home builders that are being bid up on expectations that the housing market is about to turn up sharply. Masco (NYSE: MAS), which makes a range of building materials, has joined in the housing rally.

Yet there’s a problem that looms. Housing may indeed start to turn a corner, but any increase in new home construction is likely to be painfully slow to unfold. The volume of unsold existing homes remains at a fairly high level, and that just counts the houses that are formally for sale. There are a large number of homeowners that have been loathe to unload their houses while activity remains slow. But if housing perks up, a lot of these homeowners may look to list their houses on the market as well.

Against that backdrop, these new home builders would be foolish to get ahead of themselves and start building many new homes “on spec.” As Goldman Sachs succinctly noted in a Jan. 12 report entitled “Housing is healing but not fast enough to ignore valuations,” the firm’s analysts noted that “With homebuilding stocks outperforming the market by 3,500 basis points in the last three months, we would wait for a pullback or a clearer picture that housing is healing quicker than it currently is.”

Don’t gamble on these stocks
In recent months, a number of U.S. states have expressed an interest in getting into the gaming business. Visions of hundreds of new casinos dotting the landscape have helped propel shares of companies that supply the equipment used in these gaming halls, such as slot machines, card sorting machines, betting chips and casino-oriented software. This explains why Boyd Gaming (NYSE: BYD), Scientific Games (Nasdaq: SGMS) and Multimedia Games (Nasdaq: MGAM) are all up sharply in the past few months.

Take Multimedia Games, a provider of video-gaming equipment, as an example. At a recent $10, it has soared well past Brean Murray’s $7 price target. That equates to roughly 25 times projected fiscal (September) 2013 profits. The key concern: even with the current stated plans for new casino openings in many states, this will never be a high-growth business. Sales peaked at $150 million in fiscal 2005, and are now stuck in the $125 million to $140 million range.   

Analysts at Sterne Agee say Boyd Gaming is especially ripe for a pullback. Their $6.70 price target is about 30% below the current share price, noting that cash flow will grow at a slow place this year. For this casino operator, a move to open more casinos may actually push cash flow lower as many new casinos chase a fixed amount of customers. You can imagine a scenario where new and existing casinos grow quiet as consumers have more of them to from which to choose.

If a number of new casinos get built in coming years across the United States, then what will it mean for Las Vegas? Presumably, many gamblers will choose to stay closer to home. Boyd Gaming, with 40% of sales derived in Las Vegas, would have a hard time maintaining current profit levels, let alone be able to boost profits.
Risks to Consider: The rising market lifts all boats, especially high-beta stocks like these. If the market continues to strengthen, then it may be premature to sell these fast-gainers.

Action to Take –> Some of these recent gainers have high short positions, which means their recent rally may have been fueled by short covering. If the shorts found these stocks vulnerable at lower levels and have been covering positions at higher levels in the face of an ever-rising market, then these stocks may be suitable to short at these now-higher levels. Heavily-shorted names from the table above include:

Avid Technology  (Nasdaq: AVID) 19 days to cover (which is the number of shares held short divided by average daily trading volume).

MarineMax (NYSE: HZO) 24 days to cover

Toll Brothers, which saw short interest rise from 8.8 million shares at the end of 2011 to 10.6 million shares in the middle of January

HMS Holdings (Nasdaq: HMSY) 10 days to cover

Equinix (Nasdaq: EQIX), which saw its short position jump 13% in just two weeks to a recent 4.9 million shares.

Even if you’re not looking for short sale candidates, many of these stocks look ripe for profit-taking if you currently own them in long-focused accounts.

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