Does watching the stock market surge to a new record level week after week tempt you to call your broker and cash in on some of the highfliers in your portfolio? In February, the Dow Jones industrial average topped 4000 for the first time, and, despite red flags such as a falling dollar and weaker consumer spending, on Apr. 24 it closed at a record 4304. Market strategists believe this bull still has room to run. But if you own some of the companies that have led the rally, you're probably itching to get out while you're ahead.
In general, it's best to fight the urge to unload stocks that are performing well. If you sell too early, you not only miss out on future gains but also incur taxes. Even if Congress cuts the capital-gains rate virtually in half this year--as proposed--when you sell a winner, you inevitably have less money to reinvest in a new idea.
NO SENSE. The buy-and-hold strategy has proved the best time and again. Many experts expect a small downturn in the market this summer to "correct" some inflated prices, but they still advise staying the course. "When you add up the costs of commissions, the spread between the bid and the asked price, and taxes, then match that up against a mild 3% to 5% pullback in the market, it doesn't make sense to trade out and take short-term profits," figures Jack Fisher, president of Wilson/Bennett Capital Management in McLean, Va.
That said, there are plenty of good reasons to sell. Maybe you need to raise cash, and it's a question of deciding which stock has the least potential for gains. Or maybe a company's prospects have cooled. And in an optimistic market like today's, some stocks run up so far and so fast that a slide is inevitable.
The key to identifying candidates for selling is to leave aside the larger macroeconomic issues and consider just the company's fundamental strength. And don't focus only on those stocks that have already had a good run. "The sell side shouldn't be that price-driven," says Martin Whitman, manager of Third Avenue Value Fund. "Don't sell anything unless it's grossly overvalued."
The easiest measure for judging a stock's value is its price-earnings ratio. A stock's worth is based on its future earnings potential. If those earnings are small in relation to the price, the stock can be overvalued and its p-e high. To get an accurate reading, you have to compare a company's p-e not with the market average (now at 14.6 based on '95 estimates) but with its industry. For example, a hot tech stock may not be expensive at a p-e of 25, but International Flavors and Fragrances looks pretty pricey at 25. And remember that some stocks are a better buy when they have a higher-than-normal p-e. Auto stocks typically have a high p-e at the beginning of an expansion, when their earnings are still low. That's when you should load up.
You'll also need to take a hard look at the quality of a company's earnings. As recent tumbles at U.S. Healthcare and Sybase have shown, the market is unforgiving on bad news. If a high-priced company's quarterly earnings report is lower than expected, or if a product launch falls flat, get out quick--particularly if the stock had a lot of momentum to its rise. "The first bad news is the best bad news you're ever going to get," says Michael Murphy, editor of Overpriced Stock Service newsletter, which recommends stocks to sell short. "Once something goes wrong, things tend to keep going wrong."
HIGH HOPES. With a spate of stellar first-quarter earnings being reported daily, "look for stocks that have been providing overly strong surprises and where those aren't likely to continue," advises Thomas McManus, a U.S.-equity strategist at Morgan Stanley. Many companies got a boost from the declining dollar. But if a company's earnings improved just because of exchange rates, you can't consider that a positive. For example, IBM's first-quarter earnings exceeded all analysts' expectations, driving the price up 51/4 points that week. But part of that rise resulted from exchange rates. Robb Knie, editor of The Equity Advisory, a newsletter for short-sellers, doubts IBM can repeat those earnings, since it has done about all the cost-cutting it can. "At this point, IBM has gotten ahead of itself," he argues.
The entire technology sector has been so hot that some market strategists worry it is vulnerable to a quick chill. "It seems like there are very high expectations built in," says Marc Usem, an equity strategist at Salomon Brothers. Indeed, Microsoft, Intel, and Sun Microsystems have benefited from positive earnings surprises. But disappointing news could reverse the inflows of cash that have propelled share prices.
And don't forget to consider the dividend yield (the overall market's is a low 2.6%) and dividend-payout level (the ratio of dividends paid to earnings) when weeding a portfolio. If the ratio is high relative to the industry, that's a caution signal, since it means there is likely little room to raise the dividend.
Be sure to look at who is buying and selling the stock. If you have a small company that institutions are just starting to buy, it's a good sign. Another is if insiders are purchasing more shares. But don't be too harsh on a company where insiders are selling, advises Harold Levy, manager of First Eagle Fund of America. Since that's often a major part of their compensation, "you have to expect owners to peel off shares every now and then," he says.
Only after you've looked at fundamentals should you consider the impact of any economic news. Try to ignore scary headlines, unless they have a direct impact on the companies you own. Rising interest rates are generally a bad sign for stocks, since bonds may then become an attractive alternative for investors. But you shouldn't get out of the market on news of a rate hike, unless you are heavily into financial and utility stocks, which are interest-rate sensitive.
STEADY STAPLES. There is so much optimism in the market now because strategists believe interest rates will stay low as the economy slows gradually, coming to a so-called "soft landing" from its peak. This prospect has boosted prices of consumer-staple companies, because people buy food, drugs, and soft drinks whatever the economy does. Some consumer multinationals, such as McDonald's and Anheuser-Busch, have prospered because they can participate in worldwide expansion. But consumer cyclicals, such as autos, restaurants, and retailers, are tied to a slowing U.S. economy, and their shares are getting battered.
So if you are looking to prune your portfolio, it makes sense to sell defensive stocks that are at all-time highs and buy retreating cyclicals such as paper, autos, and steel. Some of these companies are so cheap that money managers are predicting a wave of foreign takeovers. "I am convinced that, given the very weak dollar, companies in strong-currency countries are going to buy up Corporate America with a vengeance," predicts Whitman.
Selling is easier if, at the time you bought a stock, you set a target price based on the company's fundamentals and economic sensitivity. Then, when it hits the target, reevaluate. "It's not a great idea to start kidding yourself [that] it can go higher," says Murphy. "If there are genuine new reasons to think it can, that's different." And if that's the case, you may actually find yourself buying more of a stock, just when you were thinking about selling.