How to Tell if You’ve Missed the Boat on a Stock Rally
“Why didn’t I think of that?” is a very common and very frustrating thought. Realizing that you’ve missed the boat hurts.
In most areas of life, people know when it’s too late to jump on a big idea. You can’t reinvent a hot, new technology or rewrite a best-selling novel. Yet many people don’t apply the same logic to stock rallies. They see a stock on a bullish run, buy in late and end up losing money.
You see, many stock rallies end in a sort of miniature bubble. As bullish sentiment about a company spreads, investors get carried away. Eventually, the stock price reaches its logical maximum and a legitimate rally turns into a speculative craze.
These mini-bubbles might not cause recessions or bankruptcies. But they can be costly to investors who take a position toward the end of a stock rally. Those shareholders are often left holding the bag when the rally abates and the stock returns to a normal price level.
Fortunately, Alexander Green is an expert at spotting the difference between legitimate growth and late-stage bullishness. Below, we’re looking at three big signs that you’ve missed the boat on a stock rally.
Astronomically High P/E Ratios
When doing due diligence before an investing decision, you gotta look at fundamentals. Namely, the price-to-earnings ratio (P/E) – a useful way to gauge whether a stock’s valuation makes sense.
As the name implies, P/E tells you the relationship between a stock’s price and the company’s actual income. Stocks in some industries, like biotech, tend to trade at very high multiples of their earnings. Others, like consumer staples, are filled with companies which trade at low P/E ratios.
There isn’t a universal P/E limit which tells you when any stock is overpriced. Rather, you have to compare stocks to their competitors.
If a rallying stock has a P/E of 30, and most other stocks in the industry have P/Es around 20, that’s a sign that your stock is overvalued. And that means you’re probably too late to buy into the rally. On the other hand, if a stock is rallying while trading at or below the average P/E in its industry, that’s a good sign.
You can also use this approach to gauge the valuations of entire sectors, or even national markets. Just find some earnings data on relevant ETFs, calculate P/E and compare it to broad benchmarks like the S&P 500.
Back in October, Matthew Carr showed us how to manually calculate P/E. It’s a skill that every serious investor should have. But P/E ratios are also easily found on your favorite financial research site, like Google Finance or Nasdaq.com. We also discuss P/E ratios on every Stock Grader article.
As Alex said in his article on market bubbles, euphoria is another telltale sign that the bulls have gone too far.
What do we mean by “euphoria”? The Oxford English Dictionary defines it as “a state of intense excitement and happiness.” That’s not a state investors should be in. Ours is a cautious and methodical practice, not an emotional one.
And if a stock rally is getting a euphoric reaction out of investors and commentators, it implies that there isn’t much logic behind the rally – only bullish feelings. That means you’re probably too late to profit from buying in.
There are a number of euphoric phrases which are red flags when used to describe a stock rally. This time, it’s different. We see this trend continuing indefinitely. Don’t worry too much about the numbers. If you’re hearing any of these phrases, chances are you’ve missed the boat.
It’s All Over the Internet
We don’t mean to say that all online financial media is bunk. There are a number of trustworthy sources of investing news and analysis on the web. And we pride ourselves on being one of them.
But when reading about a stock rally online, it’s important to understand the difference between an informed consensus and a media fad.
If you learn about a stock rally from one of two respectable sources which cite evidence of continued room to grow, then it might be a reasonable play. But if bullish references to a stock rally are popping up all over the place – in your social media, on the news, in the first page of Google search results, etc. – then you might be late to the party.
With a little practice, it’s easy to tell when you’ve missed the boat on a big stock rally. Look for sky-high valuations, euphoria and obsessive media coverage. By learning to tell when you’re too late to a stock rally, you can ensure that you’ll be firmly on the boat for the next one.