Editor's note: This is a special excerpt from Jim Cramer's book, Jim Cramer's Mad Money: Watch TV, Get Rich. To order your copy and read all the rules, click here.
Sneak Preview: Beware Multiple Contraction
10. Look out for multiple contraction. When the economy slows down and the Fed raises interest rates, you need to beware of multiple contraction.
What is multiple contraction? It's when growth stocks with high price-to-earnings multiples — a 30 multiple is high, and anything above 40 is pretty astronomical, although this always depends on growth — get lower multiples during a slowdown, even if they deliver on their earnings and their growth estimates. You'll recall that when a stock gets a lower multiple, it gets cheaper. I can get you out of high-multiple stocks before they experience multiple contraction and lose you money, but you have to follow my instructions.
Multiple contraction happens during a slowdown for a number of reasons. First, if the Fed is raising rates, that means people are afraid of inflation. Stocks are mostly valued on the basis of their future earnings, and this is especially true of high-multiple stocks. When you have high inflation, the value of those future earnings decreases because the value of a dollar a year or two years from now is decreasing — that's the definition of inflation. That's part of why multiple contraction happens.
The big reason, though, has more to do with how investors behave, and here again I'm talking mostly about the big institutional hedge funds and mutual funds. During a slowdown the big players don't like to own high-multiple stocks. They feel like they're sticking their necks out if they own something with a P/E of 40, because the economy is slowing and they don't expect most businesses to do very well. The big funds don't have much conviction that these high-multiple stocks can deliver their earnings because of the slowdown.
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At the time of publication, Cramer had no positions in any of the stocks mentioned in this excerpt.
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