Tags: stock | moving average | PE | Tesla

2 Easy Ways to Know When You're Taking High Risks in a Stock

By    |   Monday, 07 October 2013 07:39 AM

So far (knock on wood), I've been able to avoid all of the major tops in stocks that I've been involved with, and I've also seen market tops coming ahead of time and avoided them as well.

Some people ask how I ran my dad's 401(k) up from $40,000 up to $396,000 over a number of years and I tell them about the many facets of it.

But one of the most important facets of it is being able to spot high-risk situations and simply be out of the stock or market during those times. Yes, you may miss some upside and you won't likely catch the exact top in the stock or index that you're invested in. However, you'll be so much further ahead of the game by missing the major corrections that follow. That's one of my big secrets to the success in my dad's 401(k).

Sometimes I'm early. Heck, I'm usually a bit early in making my calls for an asset topping out, but the strength in that is that I see it coming soon whereas most retail investors are so wrapped up in the moment that they are blinded to it.

Ok, so today, I want to share with you two simple ways to tell if a stock or index is overvalued, which would be considered "high risk" at that point.

The first way is a simple "visual" way of telling if a stock is becoming more risky to hold or not. If you've watched the financial media for long or if you've picked up an investing book, you've probably heard of the 200-day moving average (technically a simple moving average).

Many times this is used for investors to detect the long-term trend direction of a stock. In other words it takes all of the jagged up-and-down gyrations of the stock and plots the path in a smoothed out moving average so that you can tell, overall, if the stock is moving higher or lower.

In general, if the stock is heading higher, then you should be a buyer. And if the stock is trending lower, according to the moving average heading lower, then you'd in theory want to be short the stock. It keeps you on the right side of the trend the bulk of the time.

However, there is another valuable use for this moving average. You can look and see how far the price is extended above the moving average and tell if you're likely getting into a high-risk situation or not.

How do you tell "how high is high?" You look back at how stretched the price has gotten in the past above its 200-day moving average. If it's nearing that distance from the moving average where the stock has begun to collapse before, then there is a huge chance you're at least in the "danger zone" whether or not the stock collapses again as before.

Knowing when you're "pushing your luck" in this way, you can exit the investment and retain your profits and not have them given back to the market by a huge correction lower in the stock.

So using the distance that the stock is away from the 200-day moving average to the upside is the easiest way to tell how over-extended and risky a stock may be to hold.

Another easy way to tell how much risk you're taking on is by looking at the stock's trailing price-earnings ratio (P/E) or its forward P/E. The trailing P/E tells how the stock is priced relative to its most recent earnings, and its forward P/E tells how the stock is priced relative to its projected future earnings.

With the P/E, you are able to tell how much you're paying in price for each dollar of earnings the company makes. The lower this number, the better…the higher, the loftier the stock likely is relative to the level of earnings it puts out.

Think of it this way. Let's say you bought a pizza restaurant for $500,000 and it earned $100,000 a year. Across town, there was another pizza restaurant for sale for $1 million, yet it also made $100,000 a year in earnings. Which would you rather buy? You'd rather pay less for the same level of earnings. Well, that's the thought behind the P/E.

Many stocks or indexes are trading at a low price relative to their earnings with a P/E of 6 to 10. They're generally more fairly priced at a P/E of 13 to 16, and they're typically overpriced when they get to a P/E of 18 to 25.

Naturally, there are some exceptions to these general rules. For instance, if a stock is growing its earnings at an unusually fast pace, then it can command a bit higher P/E than the typical stock can.

But if you've been holding a stock and you pull up its chart and you see it's trading way above its 200-day moving average than it typically does and you look up its P/E ratio and it's got a P/E of 25, 30 or higher, then you know you are in a high-risk situation.

Does it mean the stock has to come crashing down tomorrow? No! Sometimes the momentum traders can push stocks up higher than they rationally should be. However, when the crash finally does come, it's so swift that you've usually given back most or all of your gains by the time you can get out. Stocks collapse far faster than they gain.

But these are two ways that you can "take the pulse" of your stock positions to see if you're in "high-risk" positions or not.

By the way, if you want a real-time example of a high-risk stock, look no further than Tesla (TSLA).

I know this is a darling of traders right now. I get that. But they have no idea how risky a stock they are in right now. And when it does come crashing down, great will be its fall. It doesn't have to be tomorrow or the next day. But once it does happen, traders will be scrambling to the sidelines in lightning speed.

Tesla has been trading in the $180s to $190s as of this writing, but its 200-day moving average is down at the $86 level. That's stretched big time!

Secondly, it has no trailing P/E because it has no previous earnings. In other words, it hasn't made money. Now, yes, it is expected to make some money next year.

But even then, the forward P/E is 919! That's insane. There is no way the stock price could ultimately sustain these high levels even with super-high growth. Anyway, that's just one real-time example that you can look at to see what a truly overvalued stock looks like by using both of these metrics. I hope you enjoyed this.

God bless!

About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust.
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So far (knock on wood), I've been able to avoid all of the major tops in stocks that I've been involved with, and I've also seen market tops coming ahead of time and avoided them as well.
stock,moving average,PE,Tesla
Monday, 07 October 2013 07:39 AM
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