Sneak Preview: Beware Multiple Contraction

Cramer's new book shows how to steer clear.
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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.

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.

That makes them skittish investors. It means that they'll sell these stocks on the slightest pretexts. During an economic slowdown with rising interest rates (a terrible environment, but a common one because at the beginning of an economic slowdown you still get a lot of inflation), most high-multiple stocks will get crushed when they report their earnings, even if they meet expectations. These companies must beat the expectations, otherwise they'll go down, because in a poor economic environment, their high multiples make them priced for perfection.

The good thing about multiple contraction is that most of these high-multiple stocks don't get really hurt until they actually report their earnings. That means as long as you're aware of the slowdown -- and it's not hard to notice a slowdown -- then you can get out before the pain starts.

This is exactly what happened with

Whole Foods

(WFMI)

and

Starbucks

(SBUX) - Get Report

in July and August 2006. I had been telling people to sell these stocks during the "Lightning Round" for months before the companies reported their earnings on July 31 (Whole Foods) and August 2 (Starbucks). I told people that given the economic slowdown, these two high-multiple stocks had become priced for perfection, and while they might deliver adequate quarters, perfection was out of the question.

Investors in both Starbucks and Whole Foods were scared because they'd seen other high-multiple stocks get cratered and because they thought the slowdown would hurt both of these companies. They were looking for any reason to sell, and I figured they would get it when the companies reported their earnings. These two companies were ripe for multiple contraction, but that didn't occur until after they reported earnings. If you owned them you had at least a month to spot the impending multiple contraction and sell the stock before it happened, because when it happens, it happens all at once.

***

Multiple contraction hurts. It's like a hard-to-diagnose cancer. But it can be spotted in time, from afar, before it is fatal, as its most important symptom -- interest rates -- rise sharply. ... But now you know how multiple contraction works, and you know to sell high multiple stocks before they report earnings during a slowdown, before everyone else sells the stock.

Those are all my new rules that I've created by analyzing my best picks on the show. If you read them carefully and obey them, you should be able to make good stock picks yourself and be able to sell stocks when you see the right indicators.

***

Editor's note: This is one of Jim Cramer's 10 Lessons From Success: Some Buy and Sell Rules, a special excerpt from his newest book,

Jim Cramer's Mad Money: Watch TV, Get Rich

, in stores now. Check back tomorrow for a new lesson.

From Jim Cramer's Mad Money by Jim Cramer. Copyright 2006 by Jim Cramer. Reprinted by permission of Simon & Schuster, Inc.

At the time of publication, Cramer had no positions in any of the stocks mentioned in this excerpt.

Jim Cramer is a director and co-founder of TheStreet.com. He contributes daily market commentary for TheStreet.com's sites and serves as an adviser to the company's CEO. Outside contributing columnists for TheStreet.com and RealMoney.com, including Cramer, may, from time to time, write about stocks in which they have a position. In such cases, appropriate disclosure is made. To see his personal portfolio and find out what trades Cramer will make before he makes them, sign up for

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