Fri Mar 14 2014
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If There’s A Bubble, It’s In These Stocks

Bull market critics have long said stocks are soaring mainly because of the Federal Reserve’s stimulus program known as quantitative easing (QE). According to QE bashers, stocks have been falsely propped up by money printing and are in a huge bubble, which will inevitably pop and make the previous financial crisis look like a Sunday picnic.

Though overly sensationalized, this argument does have some validity. By precipitating ultra-low interest rates, QE probably has many more investors than usual looking to stocks, since these now often have much better yields than bonds. But when interest rates finally become attractive again, income investors may flee stocks in droves, and a very nasty correction may result.

Still, I think the bull market critics aren’t giving the U.S. economy the credit it deserves, and I suspect their concerns about a QE-triggered financial crisis are far overblown.

Consider, for instance, that earnings per share (EPS) for the large-company-dominated S&P 500 expanded solidly — nearly 9% — in 2013. And of the 482 S&P 500 firms that had reported fourth-quarter earnings as of Feb. 28, 65% beat analyst expectations. Typically, 63% beat expectations.

Also consider the S&P’s price-to-earnings (P/E) ratio of 16. While markedly higher than a few years ago (it ranged from about 10 to 14 in 2011, for example), it’s hardly alarming or way out of whack relative to historical norms.

If there’s a bubble, I’m more inclined to point the finger at small-cap stocks.

During the past five years, the Russell 2000 index of smaller U.S. companies outpaced the broader market by nearly 7% a year, gaining an average of 30.3% annually compared with 23.6% for the S&P. As a result, the Russell now carries a much higher P/E of nearly 20, a level many market watchers would consider worrisome — especially since there’s still so much economic uncertainty.

Another sign of disproportionate risk in small-caps is so many of the past year’s leaders in the Russell have no earnings, as this table illustrates:


Shockingly, among the index’s top 10 performers during the past 12 months, only the beleaguered retail pharmacy chain Rite Aid (NYSE: RAD) has positive earnings. The rest are losing money.

This suggests investors who favor small stocks are resorting to heavy speculation in their pursuit of attractive returns because so few good values are left in the smaller-cap space. (In fact, only about 10% of Russell 2000 stocks currently trade for 10 times earnings or less.) And based on the names in the Russell top 10, the speculation involves the riskiest types of stocks — biotechnology, alternative energy, and technology companies that have rarely, if ever, turned a profit.

For instance, SolarCity (Nasdaq: SCTY), which sells solar energy systems, has been in the red two of the past three years and will likely be so again in 2014. NPS Pharmaceuticals (Nasdaq: NPSP), a biotechnology company developing treatments for gastrointestinal and endocrine disorders, has been losing money hand over fist for years, posting per-share losses of $ 0.01 to $ 4.43 during the past decade. So it makes little sense that SCTY is up more than 500% since its December 2012 IPO or that NPSP trades for 20 times sales, more than twice the industry average.

With a little digging, it’s easy to uncover plenty of similar stories among the Russell stocks I’ve listed here, as well as others in the index.

My intention isn’t to discourage investors from speculative stocks. They can have an important place in growth-oriented portfolios. And they can obviously deliver huge gains when investors believe the underlying companies are going to pan out, even if they’re not yet profitable. It’s just important to be aware that long, steep run-ups in speculative stocks can set the stage for huge losses if there are any setbacks in the economy or the companies themselves.

For clinical-stage biotech firms like NPS, shares can rapidly nosedive on worrisome news like depleting cash reserves or unexpectedly poor clinical trial results. (My colleague David Sterman recently looked atseveral biotech and health care stocks that are poised to continue soaring despite those risks.) Solar power and other alternative energy stocks are notoriously volatile and correction-prone since alternative energy is still a fledgling industry with an uncertain future.

For websites that depend mainly on advertising for revenue such as Yelp (NYSE: YELP), which provides local business reviews, profits can be elusive because of high marketing costs. Indeed, Yelp hasn’t made money yet despite fast revenue growth. Shares would likely suffer a major beatdown in a small-cap sell-off.

Risks to Consider: After years of outperformance, small-cap stocks may have reached a bubble stage where further gains depend heavily on speculation. At that stage, there’s a greatly elevated risk of the bubble bursting.

Action to Take –> Because of the high risk of a steep sell-off, consider reducing exposure to small-cap stocks soon — before the bubble bursts. Consider cutting back in particular on holdings with P/E’s of 30 or greater or no earnings at all since they’d likely fall furthest in a rout.

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