Avoiding Bubble Troubles

 | Mar 10, 2014 | 12:30 PM EDT  | Comments
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sss

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tsla

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The bull market in equities is five years old this month. Since the March 2009 nadir, the S&P 500 has nearly tripled and the Nasdaq has almost quadrupled. It has been one heck of a run for the market.

But I believe this bull-market rally is getting a bit long in the tooth. The overall market is trading at around 16x forward earnings, which is slightly above historical averages. I am not worried about a major correction in the indices but I am concerned that the sectors and stocks that have led this rise are deeply in overvalued territory. I saw a study in Barron's recently that showed more than 90% of market moves over the past five years were directly correlated to the actions of the Federal Reserve.

With the central bank retreating from the extraordinary liquidity measures it has used to support the market since the financial crisis, some highfliers are vulnerable to a significant pullback. The decline of the biotech sector at the end of last week drew numerous comments in the financial press over the weekend. The sector is still up some 75% since the end of 2012, and I will be watching this week to see if last week's late action was a blip or the start of a rotation out of the sector.

Another area that has had a massive run and has disconnected from any rational fundamental valuation metrics is 3D printing. Stocks like 3D Systems (DDD) and Stratasys (SSYS) have tripled over the past two years but pulled back some 10% last week. This will be another area worth watching this week to see if the decline continues.

The potential for 3D printing is substantial, and could change how several industries operate; however, these game-changing technologies tend to follow a familiar path. This trend has repeated itself with the invention of the automobile, the electrification of the country, and the beginning of the television and radio businesses, as well as with the build-out of the Internet.

First, a new technology with massive potential comes to the market. This development draws dozens, even hundreds, of new entrants. Investors bid up these plays on new technology into the stratosphere, which inevitably leads to a massive crash across the sector. Out of the ashes, the strongest competitors emerge and dominate the market.

The Internet boom and bust is the most recent major example of this trajectory. Yes, companies like Amazon (AMZN) survived the crash and prospered. Entrants that came to market after the crash, like Google (GOOG) also have thrived. But for every success, there was a Webvan or a Pets.com that was never seen again after the bubble burst.

Another sector that bears watching is the alternative energy space. Companies like Tesla Motors (TSLA) and Plug Power (PLUG) have had massive runs over the past year. TSLA is trading at more than 200x forward earnings and PLUG will not post any earnings in 2014. I would be wary of both and not surprised to see these names pull back substantially in the near future.

For investors who rode these sectors and stocks to huge gains, congratulations. It might be prudent, however, to trim these holdings and take some profits; no one ever went broke cashing in gains. Also, it feels as if a rotation out of these speculative areas is overdue. Tomorrow, I'll review sectors and stocks that I believe will benefit from a rotation out of these highfliers when it comes.

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