Overlooked Indicator Says It’s Time to Sell

Wyatt Investment Research

The health of the IPO market is one of many important indicators that tell us what’s ahead for stocks.

Specifically, the quantity of the deals, the amount of capital raised, and the performance of those newly public companies are powerful data points.

For perspective, let’s dial it back to the fourth quarter of 2007. A whopping 70 companies went public on U.S. exchanges. The finishing flurry brought the yearly IPO total to 213 – more than twice the tally of the ensuing two years combined. All told, those 213 companies raised $48.7 billion in their IPOs – $6 billion more than any other year in the last decade.

We know what happened next. The U.S. economy tanked.

After the dust settled, it became clear that we had endured the worst recession since the Great Depression. As a result, stocks plummeted, with the S&P 500 dipping to levels not seen in 12 years.

A second recession no longer seems likely. Despite some lingering concerns, the U.S. economy has turned a corner and is no longer on life support. However, the current IPO market is looking an awful lot like 2007.

Sixty-four companies have gone public since the beginning of May – the most in a three-month span since the fourth quarter of 2007. With 110 offerings in the first seven months of 2013, the IPO market is well on its way to its busiest year since 2007.

Given what happened the last time IPOs went wild, that’s not necessarily a good thing.

Stocks are already precariously high. The S&P 500 is trading at 19.5 times trailing 12-month earnings – the highest valuation since January 2010. The market quickly recovered from its recent 5.8% pullback, and is back to establishing record highs on a weekly basis.

If the IPO market is any indication, another correction could be imminent.

Growth stocks have gotten out of control. Each of the 110 companies that have gone public this year is either a small- or micro-cap. Many of them are trying to cash in on record stock market conditions. Given investors’ appetite for risk these days, recent IPOs are quickly escalating to ridiculous share prices after their debuts.

For example, Noodles & Company (NDLS) is trading at 214 times earnings, after rising 139% since going public last month. The ExOne Company (XONE) , a 3-D printing company, is up a preposterous 247% since going public in February despite never turning an annual profit.

Fervor over relatively unknown growth stocks is evident in the 13% average first-day pop for IPOs. That too is on par with 2007.

This isn’t the tech bubble we saw at the turn of the century. A full-on market crash probably isn’t nigh. But this growth-stock climate is unsustainable. Stocks can’t keep rising forever without hitting the reset button. And the correction we just saw didn’t qualify.

Most traditional indicators have been unreliable of late. A stagnant unemployment rate didn’t deter investors from buying stocks. Sequestration and rising European debt have done little to slow this bull market either.

Perhaps a frothy IPO market is the best evidence that a correction could be coming. But that doesn’t mean you should panic. For many investors, a decent correction would be a welcome buying opportunity.



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