You Should Be Worried About Stocks

If your investment strategy includes timing the market, then I'd encourage you to think long and hard about adding anything new to your portfolio anytime soon. For the record, I'd also encourage you to adopt a different strategy, but that's a conversation for another time.

Since the beginning of the year, the S&P 500 has rallied by 20%. Over the past two years, it's up by more than double that, or 44%.

Does this mean that stocks are too high? Not necessarily. This is something that can only be determined with precision in hindsight. At the same time, however, it's hard to ignore the ominous clouds gathering in the distance.

I discussed this at the beginning of October, when shares of Potbelly more than doubled on their first day of trading. The underlying theory was that its "expansion potential" was reminiscent of other popular fast-food chains, like, say, Chipotle Mexican Grill. Since then, they've fallen by 17% -- though, that's neither here nor there.

Whether Potbelly does or does not follow in the footsteps of Chipotle -- which, if I were a betting man, I'd go with the latter -- is beside the point. The point is rather the incredible frenzy surrounding its initial public offering. Or, to be more specific, the overall enthusiasm for IPOs that seems to be radiating throughout the markets.

Noodles & Co. provides a second case in point. Like Potbelly, its shares doubled on their June debut, and have gone on to grow by an additional 19% in the intervening months. As The Wall Street Journal noted at the time, with only 345 locations "the chain has touted its potential to expand nationally under former Chipotle executive Kevin Reddy."

And on Friday, investors welcomed the most recent member to this increasingly nonexclusive club, The Container Store . On Thursday night, a collection of well-financed and highly sophisticated institutional investors agreed to pay $18 for each share of stock in the popular home-organizing retailer. One day later, individual investors ponied up $35 a share. You do the math.

To be clear, this isn't how IPOs should behave. And to many experienced investors, it's a clear sign that the market is overheated. Here's what Benjamin Graham, the father of value investing, said 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.

Because Graham is a much more recognized source than I am, I don't have much to add to his warning, other than to say that it's probably as true today as it was when he wrote those words a half century ago.

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