I hate to be the bearer of bad news, but there is a bubble forming in the stock market. Or rather, I should say there are bubbles forming—particularly with some high fliers trading on the NASDAQ.
Stage one of market rallies is broad based because investors move back into the market through index funds and ETFs. These are baskets of stocks that create a rising tide across a wide swath of stocks. What you see is strong buying pressure moving into stocks that don’t deserve it.
It just happens that they are included in popular funds or ETFs. So, when the smart money moves from indexing to fundamentally superior stocks, the bubbles under inferior stocks will burst without notice.
A great example is Tesla (TSLA). I’m a car guy, and there’s no doubt Tesla makes great cars. But the stock? I wouldn’t go near it, even with the company’s explosive sales and earnings growth.
Over the summer, TSLA was added to the NASDAQ 100 (QQQ) to replace Oracle (ORCL). As investors bought the QQQ, money flowed into TSLA as well, automatically increasing buying pressure in the stock. The problem is that this indiscriminate buying comes without any valuation analysis. In TSLA’s case, it got so ridiculous that the company hit a market capitalization in excess of $23 billion, which is over 10 times its annual sales pace and 440 times its forecasted earnings! And it’s not just the QQQ.
Plenty of other index funds were buying Tesla as well, such as those with a small-cap bias or those that go after explosive sales and earnings. But after piling into this stock for months, the day of reckoning came on November 7, when TSLA shares plunged to a two-month low on a weak fourth-quarter forecast. This stock is down over 15% since reporting earnings and I don’t expect it to recover anytime soon.
I believe that this cautionary tale will play itself out several other times before earnings season is through. So while I like strong sales and earnings momentum, I always make sure to “look under the hood” so we avoid paying excessive valuations. And when I see grossly overvalued stocks, I get out—and fast! To help you avoid overvalued stocks like Tesla and sidestep big stock losses, I recommend you continue running your current holdings through my Portfolio Grader stock screening tool. I’ll continue keeping an eye out for potential pitfalls and profit opportunities as we wrap up earnings season.