Two Stocks to Sell Heading Into 2013

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Over the last year, home improvement companies have been among the top performers in the market. Investors have found a safe haven in the leaders within this industry, both Home Depot (NYSE: HD) and Lowes (NYSE: LOW), as the housing market shows some signs of life. However, with signs of being overvalued and a potential correction on the way, investors might be best suited to take profits.

During the last year the S&P 500 has returned a gain of 15.84%. During the same period the Home Improvement index has tripled its performance with a 45.17% return. These gains have been led by Home Depot’s 57% return and Lowes’ 41% gain. However, there are now reasons to sell.

Record P/E Ratios & Limited Growth

Last week I was looking at the trend and valuation of Home Depot and thinking to myself that it reminded me a lot of McDonald’s (NYSE: MCD). This might sound like a strange comparison, but to me it made sense.

Consider the fact that McDonald’s rallied 130% over a five year period with very low double digit growth. Investors found comfort in the stock with the belief that consumers would eat more McDonald’s due to tight family budgeting; and due to the addition of McCafe. However, as the stock continued to outperform fundamentals its metrics also became more expensive. Both its P/E and price/sales ratios were trading at record highs and a correction occurred.

Now, back to home improvement stocks, both Home Depot and Lowes are seeing a similar trend as what we witnessed with McDonald’s, only it’s far worse. McDonald’s was seeing year-after-year of top and bottom line growth during its rally, but Home Depot and Lowes have posted mediocre growth, and are trading with worse fundamentals than in 2008. However, both stocks are trading with record P/E and price/sales ratios.

 The reason this is significant is because the recession was caused by a housing bubble and an eventual collapse. Therefore, both Home Depot and Lowes should’ve traded with much larger valuations during this period of time, as more materials were being sold. Basically, the fact that both are valued higher today based on pure speculation is a scary thought, meaning there could be a significant correction ahead.

December Weakness

Despite the fact that both stocks have continued to outperform the market and fundamentals for the last two years, there has been nothing to slow down their rally. However, eventually a correction always occurs, and both stocks are in dire need of a correction. With that being said, I find it interesting that both stocks are now trading lower in December as the market has traded higher. Is it possible that we are seeing the correction?

Since December 3, The Home Depot has lost 3.30% of its value and Lowes has lost 3.55% of its worth. Meanwhile the S&P 500 has rallied about 1.0%. Perhaps this means nothing, but in my opinion we will see significant weakness and heavy selling pressure into the first half of 2013.

I will conclude with my reason for why I believe both The Home Depot and Lowes will trade lower in the first six months of 2013. Keep in mind, the excessive valuation still exists, which is the catalyst for the downward selling pressure. But my reason is due to institutional ownership, which ties everything together.

The Home Depot has institutional ownership of 74% and Lowes has 77%. Both stocks have been a favorite for various funds and institutions because of their returns. However, with such a large presence of institutional ownership it means the direction of the stocks is dictated by the actions of those institutions. Therefore, selling in December could indicate that institutions are identifying the stock as being overvalued and are now trying to sell before the beginning of next year.

Why would institutions want to sell before the end of the year? Well, think back to the end of last year and the beginning of this year, and remember when financial stocks were hammered during the final six months of 2011. But, in January, like magic, all of those beaten down stocks began to recover, such as BAC and C. The reason is because institutions identified them as being undervalued. It’s the same reason that McDonald’s began to selloff in the beginning of 2013; because funds rebalanced their holdings and MCD was overvalued. Whether or not this happens or not is anyone’s guess. But in my opinion, all the signs are present for 2013 to be a rough year for these two stocks. Both are trading with record valuations compared to fundamentals and are seeing weakness in a month where gains are everywhere. I view this as a big indication of what’s to come and a sign that retail investors should take profits off the table.

BrianNichols has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend The Home Depot, Lowe's Companies, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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