Short This Extremely Overvalued Stock
By Jody Chudley | October 02, 2014 |

Do we or do we not have a stock market bubble in the United States today?  Looking back on the last fifteen years, almost all investors are familiar with how painful the popping of a stock bubble can be.  We have learned that we can't ignore the overall valuation of the market if we want to avoid being part of the carnage.

In 2000 investors saw the dot-com bubble pop, which led to huge losses for holders of internet and technology-focused companies. In 2008 there was no sector left unscathed by the financial crisis that caused the worst selloff since the 1930s.

Today, one renowned investor is ringing the alarm bells -- warning of a significantly overvalued stock market. According to market strategist John Hussman, the only points in U.S. stock market history that match today's level of overbought and overvalued assets are 1929, 1972, 1987, 2000 and 2007.

As you are likely well aware, each of those points in time were followed closely by a stock market collapse.

Personally, I'm not sure that we are in a stock market bubble, but I can tell you one thing for sure. When the trailing five-year chart for the S&P 500 looks like the image below, it is time to be very, very cautious.

S&P 500 Chart

That is an entire index of the 500 largest publicly-traded companies in the United States and it has nearly tripled over a five-year period, folks. To say that we have experienced a bull market would be a significant understatement.

To avoid a drubbing in a stock market correction, which seems more likely than not, you don't have to sell the stocks that are attractively valued. 

Instead, hedge your portfolio by selling short or buying puts on some companies that are clearly expensively valued.

With that in mind, Skechers USA, Inc. (NYSE: SKX) is as an attractive option for part of a diversified hedging program.

Sketchers Chart

Skechers shares have risen to nearly $60 today from $15 at the start of 2013 -- that alone is not reason enough to bet against the shares of a company.

What we need to think about is the operational performance of the company and how those shares today are valued against it.

Operationally, Skechers has had a very good run, there is no denying that; however, shares could decline by a significant amount. You see, the market is currently assigning a rich valuation to what I believe are "peak" earnings for this cyclical business.

Skechers is a shoe company and, more specifically, a shoe company that has very unique designs. Skechers annual success is directly related to how accurately it predicts what is going to be popular each fashion season.

When Skechers guesses right, the company does very well.  When it's wrong, it has a bad year.

We don't have to look far back to see how cyclical Skechers' operations are. Skechers' earnings per share over the past several years have looked like this:

   

YearEarnings Per Share
2009$1.18
2010$2.87
2011-$1.39
2012$0.19
2013$1.09

The best year for the company was 2010 when earnings per share were $2.87 -- at its current share price of $60, SKX would have a price-to-earnings ratio of 21.

The average earnings per share for the four best years listed above -- excluding the firm's negative EPS in 2011 -- are $1.33. On today's $60 share price that would be a whopping price-to-earnings ratio of 45.

I can say with full confidence that a company operating in a cyclical industry should not be valued at 45 times its average five-year earnings level. I should also mention that if I included Skechers' worst year -- where SKX had to write off a significant amount of assets -- the P/E would be sit around 76.

What kind of company would merit a P/E ratio of 45?  Maybe a young technology company with a moat around its business that could allow for decades of significant growth in the future --perhaps Google (Nasdaq: GOOG) in its early years.

To give the company credit, 2014 has been another good year for Skechers. Earnings for the first half of 2014 were $1.30, or an annualized $2.60. That equates to Skechers trading at a P/E ratio of 24.

Again, I believe that this is a cyclical business and should be valued as such.  It should not be valued at a P/E of 24, which is a valuation appropriate for a great business with clear room for multiple years of strong growth ahead.

How far could Skechers' shares fall?  A return to its five-year average EPS of $1.33 in 2015 would be a 50% drop from 2014.

That would put Skechers share prices at about $16, or one quarter of where shares trade today -- a 75% decline in the stock price.

There is no guarantee that is going to happen, but it is a high possibility because all it would take is a more normal year of earnings. At the very least, it is hard to imagine Skechers' shares increasing from here.

When it comes to companies like Skechers you want to sell the shares when business is booming and get interested in buying them after a bad year.

After all, this is fashion -- there will be some hits and some misses.

Risks to consider: When you are long a stock the most you can lose is 100%.  When you short a stock your loss can be unlimited. Short positions should be small and always institute a stop-loss measure to protect against infinite losses.

Action to take --> At the very least Skechers shares should be avoided. If you are interested in hedging your portfolio, Skechers could make for a good part of a diversified group of short positions.

Shorting stocks is not the only way to ride out a potential market correction. Not only has the strategy returned an average of 15% per year since 1982, but it's outperformed the S&P during the "dot-com" bubble and the 2008 financial collapse too. To learn more about his "Total Yield" investing strategy, click here.

This article originally appeared on StreetAuthority.com: Short This Extremely Overvalued Shoe Company

 

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