Avoiding a Downturn

One of the best ways to sidestep a market nosedive is Cramer’s rule for multiple contraction.

If you’re new to the game, a stock’s multiple is just the price of the stock divided by the earnings. It shows you what the market’s willing to pay for a certain level of earnings per share. Multiple contraction means the market will start paying a lot less for the same amount of earnings.

Only certain types of stocks are truly vulnerable to a multiple contraction – those with a high-multiple. Any stock that trades at more than 30 times forward earnings estimates could catch multiple contraction, Cramer said. Anything with a PE over 40 is almost begging for it. When the market takes a dip, Cramer advises you identify the high-multiple stocks in your portfolio.

Here’s an example of how things usually play out: You’ll see evidence of a slowdown or the Fed will hike rates a bit too far like it did in May 2006, and a lot of stocks that had been working will stop working. They’ll start going down. But you won’t see a severe multiple correction until your stock reports earnings, which is what happened to Whole Foods at the end of July that year when its same-store sales growth came in 0.1% below estimates. By then, the market had been ugly for months, and investors already were pessimistic about most high-multiple stocks. That report looped in Whole Foods with the rest. The stock dropped 10% overnight.

If you want to avoid taking serious losses, then beware of multiple contraction. If you see a slowdown, you see a rate-hike that the market doesn’t like, then you should probably sell your high-multiple stocks before they report unless you want a world of pain.

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