If the market stumbles these 4 stocks could take a tumble

It can be sensible to avoid owning significantly over-priced stocks, particularly if a market correction is imminent.

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Investors are rightly cheering the U.S. market hitting a new all-time high and likewise the S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) clawing its way back to levels last seen in mid-2008 before the worst of the Global Financial Crisis (GFC) set in. However as markets grind higher, it is important for investors to re-evaluate if any stocks in their portfolios have run too hard and are now expensive. This is an important consideration as investors who own overpriced stocks don’t leave themselves much room for error which can become particularly evident should the market enter a correction phase.

Recently the Head of Australian Equities, David Poppenbeek, from listed fund manager K2 Asset Management Holdings Ltd (ASX: KAM), highlighted that valuation risk amongst what he termed the “market darlings” was increasing. These “darlings” have attributes such as predictable free cash flows, high returns on capital, significant barriers to entry, and profit momentum well above peers. These appealing attributes have pushed the average of next year’s price-to-earnings (PE) ratio of the group out to 26.4, which is more than 70% higher than the wider market.

Poppenbeek goes on to point out that pre-GFC this group traded on a PE of 22.1, which at the time was a 26% premium to the wider market. However during the GFC these “darlings” fell sharply and were de-rated to an average PE multiple of 14.5.

So what are some of the companies that Poppenbeek singles out to be wary of? REA Group Limited (ASX: REA), Ramsay Health Care Limited (ASX: RHC), CSL Limited (ASX: CSL) and Platinum Asset Management Limited (ASX: PTM) all rate a mention.


Foolish takeaway

On the issue of a market correction, recent data has highlighted that on a number of metrics this bull market is starting to look a little long in the tooth. Last night’s 1.4% fall in the Dow Jones adds to the recent volatility and the concern that a market correction could be imminent. While a correction doesn’t mean anything like the GFC is about to occur, or that investors should necessarily sell the above mentioned stocks, it could be worth investors taking the time to consider the downside risks in their portfolio.

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Motley Fool contributor Tim McArthur does not own shares in any of the companies mentioned in this article.

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