When to Leave the Party

Mind Over Markets

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When to Leave the Party

Linda McDonough

If your December was anything like mine, you found yourself at holiday parties questioning the best time to leave. There's that tipping point as the fun accelerates when a decision must be made: Although staying will mean a ton of fun, the next day's recovery might be a stiff price to pay.

Knowing when to sell a winning stock is a lot like knowing when to leave a great party.

The riotous bull-run that's lifted stocks since the election leaves many portfolio managers in a similar quandary. The S&P 500 is now trading with a forward P/E ratio of 17 based on estimated 2017 earnings. This ratio stood a little above 15 one year ago and has only poked above 17 once in the past ten years. Earnings are expected to grow just 10% in 2017, higher than last year's growth but well below its 17 PE.

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Many groups, like the materials and industrial sectors, are up more than 10% since the election. But what is a portfolio manager to do? Most of these stocks have risen without a commensurate increase in earnings estimates. The stocks are expensive based on current earnings but might likely run higher as optimism for federal spending ferments.

Selling a stock presents two problems for the portfolio manager. The first is the risk of losing out on additional upside if a stock continues to soar after he sells it. We've experienced this first hand with our sell of Drew Industries (recently renamed LCI Industries). The stock was up 35% during our six month holding period. It was trading with a PE well above its growth rate so we decided to lock in that significant gain.  Yet the stock has gained another 5% since our sale (no regrets, of course – you can't go wrong making that much money).

The second problem, which affects the individual investor less, is the nagging problem of what to replace that sold stock with in your portfolio. Most money managers are judged based on their performance versus the market averages and many operate with protocols that limit the amount of cash they can hold. Although holding cash can protect a fund's performance in a down market, it is dead money when the market is rising and will guarantee under performance, the scourge of professional money managers.

This is the problem I've been grappling with at Profit Catalyst Alert. We have several stocks in the portfolio that are up more than 30%. I've been reviewing estimate updates and analyzing the underlying assumptions to make sure these stocks are worth more than their current prices. I'm working feverishly to find new names to replace the ones that must be sold but bargains are few in this market. Luckily for Profit Catalyst subscribers, our inventory for new trading ideas includes options which can capture short term moves in stocks and offer ways to make money when a stock stumbles.

Knowing when to leave a boring party is easy. If a stock is not working out or reports disappointing earnings, it's an obvious choice to kick it to the curb. But when the screen is green and the party is gaining momentum, the decision to head for the exits is a tough task.

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