We Now Know That Stocks Are Too Hot


There have been signs over the last year that stocks are getting overheated, but yesterday gave investors the clearest indication yet that this is indeed the case.

On Friday, Potbelly Corporation went public to wide acclaim. Shares of the sandwich maker finished the day nearly 120% higher than where they started.

The storyline throughout the mainstream financial media is that restaurant stocks are in high demand right now, and that Potbelly, in particular, has a lot of room to run.

"It is gaining a lot of interest in areas outside the Mid-West where it seems to be focused currently, and expansion potential seems to be reminiscent of popular food chains that are going to succeed in markets," a financial executive told Reuters' Avik Davis.

To be fair, Potbelly isn't the only restaurant stock to have a soared on its first day of trading this year. Shares of Noodles & Co. doubled on their debut in June. "We've been delivering some of the best results in the restaurant industry in the last five years, and the market, understands that and respects that," said the company's CEO, Kevin Reddy, at the time.

But the story that companies like these are in unusually high demand right now, or that they're in a much better financial position, doesn't adequately explain investors' appetites for them. It also doesn't explain how investment bankers at no-less-than Goldman Sachs , which was the lead underwriter on the Potbelly deal, could have gotten the valuation so wrong.

Rather, a fuller explanation probably has more to do with the level of stocks, generally. I spoke about this briefly here, in a piece about the dramatic uptick in public offerings this year.

At the end of last week, the S&P 500 closed just under the 1,700-point threshold. This is just short of its all-time high, and equates to an almost 50% increase over the last two years.

At this stage in a bull rally, companies flock to the public markets for the obvious reasons: Investors, operating under misplaced feelings of euphoria, suspend reason, and are willing to pay considerably higher multiples for new issues than at other times.

Benjamin Graham, the father of value investing, touched on this in The Intelligent Investor (emphasis added):

Our one recommendation is that all investors should be wary of new issues -- which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased.

There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under 'favorable market conditions' -- which means favorable for the seller and consequently less favorable for the buyer.

The point here is not to predict a market crash, as that's the province of fortune-tellers and other types of soothsayers who masquerade on CNBC as self-described experts. But, at the same time, signs like this that suggest stocks may be too high right now should nevertheless be acknowledged and respected by investors, irrespective of what the market's going to do tomorrow, next week, or next month.

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Originally published