7 Must-Know Stock Market Sell Signals
Author: Brandon Smith
Before we talk about the specific indicators that would signify stock market sell signals, we must understand why we bought each stock in the first place. The simple theory of ‘buy low, sell high’ seems practically very easy, but the reality of the situation is much more complex. When investors look to spend their hard earned cash on stock market investments, it is absolutely necessary that they buy stocks when they are relatively undervalued in comparison to the company or market as a whole. What investors need to assume is the fact that you make money at the price you buy at, not the price you sell. It is imperative as an investor that you understand both sides of the coin when it comes to buying and selling stocks. A breadth of knowledge in technical, fundamental, and psychological factors that affect stock prices will give you an edge.
How You Buy a Stock
Many factors can be used to help look for and find buying opportunities. When buying stocks, look for low price-to-earnings or P/E ratios relative to the industry average or a P/E ratio that is near the low of its five-year range. Find companies with strong earnings and ones that have an economic moat that will protect said earnings. Use short-, medium-, and long-term charts to identify if the stock has a history of growth. You’ll be surprised how many companies don’t make money or make less than before, and the stock chart usually reflects that. Finally look at the business you are interested in from afar. Is it growing? Does it change the world we live in positively? How does its competition look? Utilize everything you can when looking to buy stocks. Trades should be based on calculated risk. Without that, you are gambling.
Stock Market Sell Signals
Now that we’ve discussed why we would buy a stock, let’s dive into why you should sell a stock. As the market moves, it’s important to keep an eye on how your company looks from a financial standpoint. Below we will discuss in detail some key fundamental metrics that could be used to signal that a stock is overvalued, also known as stock market sell signals.
Price-to-earnings (P/E)
The P/E ratio is used to show how expensive a stock is relative to the money it earns. The first check you can perform on any stock is to compare the stock in question’s P/E with the sector average. If the stock’s P/E is higher than the sector average, then the stock is relatively more expensive than the sector’s average and can be considered a sell signal. Some companies (typically tech companies) carry a high P/E due to the public pricing of future earnings. This is why the next step would be to compare the stocks P/E within a five-year range of its own P/E. If the stock is near the top of the five-year range, then it’s more overvalued than it has been in the last five years, which could be an indication to sell.
Next, with a word of caution we can look at the Forward P/E. I say with a word of caution because this is based on analysts’ expectations and guidance set by the company. Don’t forget these are educated guesses – they can be spot on or miss the mark completely. Typically, when the Forward P/E is higher next year than the current P/E, there is a projection of lower earnings. Most, if not all, investors should invest in companies projected to make more money quarter over quarter and year over year. This too could be used as a signal for when it’s time to sell a stock. With some simple yet advanced tactics, you can even project the stock price in a range for the next year.
Price-to-Book (P/B) Ratio
The price-to-book (P/B) ratio is a comparison between the market valuation and the book value of the company. A good buy point for any stock is a P/B under 1. But, when a stock’s P/B is higher than the sector average, then it’s relatively expensive. This comparison could be used to signal when to buy or sell depending on what the P/B is at, as well as how to compares to the industry average. Another word of caution - use this as a checkpoint and not a definitive buy/sell signal. Sometimes companies can window dress book value causing the P/B to appear lower than it really is, so again be cautious.
Earnings Per Share (EPS) Growth Next Year and Next 5 Years
Earnings per share (EPS) growth uses projected earnings to give us a glimpse into what may happen next year. This can also be used to understand trends. Is the company constantly growing its earnings? Is it stable, consistent growth? If the answer differs from its history, it could be one of our stock market sell signals. The importance of earnings growth is that the stock price inevitably follows earnings. Some newer companies could have growth based on expected future earnings, but the stock price generally reverts to the mean at some point - all based on the company’s actual earnings.
Debt Load Management
If a stock has a debt load, it is important to assess how management is handling it. Is management letting debt grow or paying it down faster than expected? The answer is important because a building debt load increases the interest expenses the company will have and therefore affect the bottom line.
We want to focus on year-over-year changes in the debt/equity ratio as well as the long-term debt/equity ratio. We want these ratios to either be a low stable number relative to the industry average or we want to see that management is actively paying it down. In doing so, shareholders equity or the value of the shares you currently own will increase. When the opposite is happening, such as erratic or increasing debt loads, we should be concerned and possibly ready to sell. If you want to look at a year-over-year trend of these statistics, Charles Schwab has some great tools that come with its account. Below we can see the five-year trend in graphical form to the left, a definition of the ratio in the middle area, and the current value of the ratio to the right for a sample company.
Do you want to open a Charles Schwab account to access these awesome features? Click this link to sign up, it only takes minutes! http://www.schwab.com/public/schwab/nn/refer-prospect.html?refrid=
The Big Picture
Sometimes the best way to tell if it is time to sell a stock is to see if the story has changed.
Changes in Business
Before you ever invest in a company, it is imperative that you look at the business from every angle. It is necessary as an investor to know what you are buying and why you are buying it. You would not buy a car without test driving it, would you? Typically, you look at Consumer Reports, talk to people who have owned that car model, and look at safety ratings and mechanical flaws or misnomers. The same can be said for stocks – look for changes in the income statement, balance sheet, and statement of cash flows. When these things begin to change from your initial thesis, it may be a stock market sell signal.
Changes in Management
When management changes, it may be time to sell. Typically, stock prices fall when new management is announced because a different mindset is at the helm of the company. People may have the same goal, but different paths to reach said goal. The story can change on a multitude of levels. Even if the financials are still intact, if the story about who it is as a company or what it does has changed, it may be one of our stock market sell signals.
An example of this is the Chinese company, Lukin Coffee, which, from its financials, was poised to be the next Starbucks. It was later realized that the earnings were not as they seemed and they were forging financial documents. The stock tanked and has since been delisted from the NASDAQ. Sometimes you can see the smoke before the fire and get out of a stock, and sometimes you will have to get out while down to prevent a total loss. As a caution, though, a decrease in a stock price isn’t always a sell indicator. In fact, in some cases it may be a chance to buy more of the company’s stock. So, you’ll want to be sure to understand why the stock price has decreased.
Sector Rotation
The stock market moves in and out of sectors like the tides in the ocean based on the current point of the economic cycle. Understanding where money is moving in and out of could be used as a signal for when to sell a stock. The best way to grasp this concept is to take a step back and look at the overall economy. During times of fear, the best investments tend to be non-cyclical defensive positions like grocery stores and household goods. In a depression or economic contraction, you may not buy a new iPhone, but you will still buy bread and toothpaste for your family.
Many graphics can be found by googling ‘sector rotation’ to give you a better idea as to what are the best sectors to invest in based on the economic picture at hand. Trying to time the market tends to not be a successful strategy. The old saying goes, ‘time in the market is better than trying to time the market. Use sector rotation to either sell at right time or buy on the dips when the sectors rotate.
Portfolio Rebalancing/Profit taking
As you build your portfolio, if you invest in great companies, then eventually the underlying stock prices should rise. As those stock prices rise, the overall percentage that it takes up of your portfolio rises as well. For most passive investors, any one stock should not take up more than 3-5% of your overall portfolio to avoid company specific risk.
Closing Thoughts.
Now you have some stock market sell signals! Remember that you should only invest in what you know. When things start to change, do whatever you have to in order to protect your money and continue to grow your wealth. Good luck investing!
About the Author
Brandon Smith is the owner of Launchpad Finance, which was a financial education source for young adults and new investors. Brandon has been studying and trading in the stock market for over 6 years now, and has been interested in the markets since he was 12 years old. After graduating from The University of Houston with a BBA-Finance, he used his passion for the stock market to start Launchpad Finance to fuel others to have a passion for stock trading, as well as grasp of the value of financial literacy in one’s own path to financial freedom.
