Warning Flags Are Flying

Is the stock market exhausted after five years of impressive gains? And if that’s the case, what should you do to protect yourself from possible sharp and/or prolonged pullbacks?

Top investment strategist Pat Dorsey says that we will see a lot more volatility this year—and that it’s time to consider shifting at least part of your portfolio from riskier investments to ones that can hold up well in choppy waters.

Bottom Line/Personal spoke with Dorsey to find out which stocks you may want to jettison or avoid and which can provide relative safety in case there is a big downturn…

FOCUS ON VALUATIONS

Since the market bottomed out in March 2009, the Standard & Poor’s 500 stock index has nearly tripled. Even though the bull market is still alive, I am being more cautious this year for a few reasons.

Although the market is far below the valuations that preceded the crash of 2008, it is no longer cheap. The most common measure of valuation—the “forward” price-to-earnings ratio (P/E)—recently was 16 for the S&P 500 based on expected earnings for 2014, compared with the historical average over the past century of 15. In addition, investors are jittery after last year’s surprisingly big gains.

At the same time, I don’t want to just dump all of my stock holdings and rush into bonds or cash in anticipation of another crash. The economy is expanding moderately…US manufacturing growth in January reached its highest level since 2010…and I expect corporate earnings to grow at a percentage rate in the high single digits.

What to do: Review the valuations of every stock in your portfolio. If a stock is trading at a P/E substantially greater than that of the S&P 500 and greater than its own average P/E over the past five years, investors are likely to dump it as soon as the market starts to decline. Stocks with lower P/Es that meet their earnings expectations have a better chance of falling less than the broad market. You can find P/Es at Morningstar.com.

STOCKS TO SELL OR AVOID

Overvalued stocks that you should consider selling or avoiding now include several hot, trendy stocks. These Wall Street favorites have experienced massive run-ups in share price and valuation over the past year. Examples…

ExOne Co. (XONE). This 3-D printer company went public in February 2013, and the stock rose by 155% by the end of the year. But it still is unclear how this exciting technology will translate into real-world applications. The stock recently had a P/E of 61 even though its price has fallen by 34% this year. Recent share price: $39.93.

Tesla Motors (TSLA). The electric car manufacturer, which has found a cult following with its $70,000 Model S sedan, has shaken up the automobile industry. But the stock, which has shot up by more than 500% in the past year, now trades at about 67 times its estimated 2014 earnings. With valuations that high, Tesla is under enormous pressure to show that its new electric crossover vehicle, the Model X, slated to debut late in 2014 or early 2015, can be successful in a highly competitive category. Recent share price: $230.97.

Twitter (TWTR). Shares of this Internet messaging company, which has more than 240 million monthly users, soared 182% within seven weeks of the stock’s initial public offering (IPO) last November. But its P/E recently was an unnerving 564, and it competes for dollars with bigger juggernauts such as Facebook and Google. Recent share price: $51.92.

Under Armour (UA). The sports garment maker’s popularity among professional, college and other athletes helped drive up the stock 80% last year. But its P/E recently was 52, more than double that of competitors such as Nike and Lululemon Athletica. Under Armour does not own any patents on its fabrics or manufacturing technology, which means that other companies can copy its products and take away business. Recent share price: $117.35.

STOCKS TO HOLD OR BUY

The safer shares to own this year are likely to be stocks of high-quality companies with modest P/Es. Hang onto these if you already own them, and consider buying them now as long-term investments that may be able to stand up to market volatility. These are in categories such as the following…

Big tech. Many large-cap technology companies are experiencing slower growth than the more than 20% annual growth they managed in the past. Even though they are excellent businesses with solid balance sheets, many investors have lost interest, leaving their stocks undervalued. Worth considering now…

Qualcomm (QCOM). This is a top manufacturer of semiconductors for major cell-phone makers including Apple and Samsung. Its recent P/E of 13 is far below its historical average of 24. Qualcomm should see robust global revenue growth as more smartphones and tablets hit the market and carriers expand networks. The stock lost 7.4% in 2008, compared with a loss of 46.3% for the overall communications equipment category. Recent share price: $74.74.

Oracle (ORCL) is the world’s leading maker of database-management systems. It recently had a P/E of 12, compared with a historical average of 18. The stock lost 21.5% in 2008, compared with a loss of 40.2% for the overall software/infrastructure category. Recent share price: $37.60.

Undervalued dividend-paying companies. These companies have reliable profits regardless of how the broader economy is doing and pay large dividends that serve as a buffer in market downturns. Worth considering now…

AmeriGas Partners (APU). The largest retail propane supplier in the US has plenty of room to grow in the highly fragmented industry. Because it is structured as a master limited partnership, it passes most of its cash flow to shareholders—and the stock’s recent yield was 7.9%. Recent share price: $42.45.

Philip Morris International (PM) is the world’s second-largest tobacco company. Although its controversial product makes it the wrong choice for some investors, its recent P/E of 13 falls below its historical average of 16, making the stock attractive. Demand for cigarettes in Asian markets continues to be a key driver of growth. Recent yield: 4.5%. Recent share price: $79.89.

Southern Co. (SO). This utility company provides electricity for four million customers in Georgia and surrounding states. Unlike many regulated utilities, its annual earnings growth has been strong because of the rising population and industrial growth in the Southeast US. Its P/E was recently 15, compared with a historical average of 18. Recent yield: 4.7%. Recent share price: $43.49.