How to Invest in an Overvalued Market

The stock market has been on a remarkable run since the pandemic-induced crash in March 2020. The S&P 500 index has more than doubled from its low point, reaching new record highs almost every week. Many investors are wondering if the market is overvalued, and if so, how to invest in such a scenario.

What Does It Mean to Be Overvalued?

A stock or a market is considered overvalued when its current price exceeds its intrinsic value, which is the present value of its future cash flows. There are various methods to estimate the intrinsic value, such as the discounted cash flow analysis, the price-to-earnings ratio, or the asset-based valuation. However, there is no definitive or objective way to measure the intrinsic value, as it depends on many assumptions and estimates.

One popular indicator of market valuation is the Shiller PE ratio, which compares the current price of the S&P 500 index to its average earnings over the past 10 years, adjusted for inflation. The higher the ratio, the more expensive the market is relative to its historical earnings. As of October 2023, the Shiller PE ratio was 38.6, which is well above its long-term average of 16.8 and its median of 15.81. This suggests that the market is overvalued by historical standards.

Why Is the Market Overvalued?

There are many possible reasons why the market is overvalued, such as:

• Interest rates: A lot of central banks have increased interest rates over the last two years to combat a higher amount of inflation. Generally, low interest rates make borrowing cheaper, stimulate economic activity, and boost corporate profits. They also make stocks more attractive relative to bonds and other fixed-income investments, as they lower the discount rate used to value future cash flows. However, the opposite is true for higher interest rates, which is why we have seen the market have a massive run on the back of predictions of rate cuts over the short-medium term.

• Fiscal stimulus: The U.S. government, and the majority of developed economies, has enacted several fiscal stimulus packages to support the gloably economy during the pandemic, accounting for trillions and trillions of dollars. These stimulus measures have increased consumer spending, business investment, and public infrastructure. They have also increased the money supply and the federal debt, which has lead to inflation and potentially higher taxes in the future, however the central banks seem to think they have done a good enough job currently to stem and even beat inflation.

• Earnings recovery: Despite the pandemic, many companies have managed to maintain or increase their earnings, especially in the technology, health care, and consumer sectors. These sectors have benefited from the shift to online services, e-commerce, and digital entertainment. The earnings recovery has boosted investor confidence and optimism about the future growth prospects of these companies.

• Emotional trading: Some investors may be driven by emotions, such as fear, greed, or FOMO (fear of missing out), rather than rational analysis. Emotional trading can lead to herd behavior, momentum, and bubbles, which can inflate the market price beyond its fundamental value. Some examples of emotional trading are the GameStop saga, the meme stock craze, and the cryptocurrency frenzy. And now potentially the AI driven bull market that we see before us.

So, How do we Invest in an Overvalued Market?

Investing in an overvalued market can be challenging, as it involves balancing the risk of a market correction or crash with the opportunity of further gains. Some possible strategies are:

• Diversify your portfolio: Diversification is a key principle of investing, as it reduces the exposure to any single asset, sector, or market. By diversifying your portfolio across different asset classes, such as stocks, bonds, commodities, real estate, and cash, you can reduce the overall volatility and risk of your portfolio. You can also diversify within each asset class, by investing in different sectors, regions, and styles, such as value, growth, or dividend stocks.

• Rebalance your portfolio: Rebalancing is the process of adjusting the weights of your portfolio to match your target asset allocation, which reflects your risk tolerance, time horizon, and goals. Rebalancing can help you maintain your desired level of risk and return, and avoid being overexposed to any asset, sector, or market. Rebalancing can also help you take advantage of market fluctuations, by selling high and buying low, and locking in your gains or losses.

• Set stop-loss orders: A stop-loss order is an instruction to sell a security when it reaches a certain price level, which is usually below the current market price. A stop-loss order can help you limit your losses and protect your profits, in case the market drops sharply. However, a stop-loss order can also backfire, if the market rebounds quickly after triggering the order, or if the order is executed at a lower price than the specified level, due to market volatility or liquidity issues.

• Consider shorting for experienced investors: Shorting is a strategy that involves selling a security that you do not own, with the expectation of buying it back later at a lower price, and profiting from the price difference. Shorting can be a way to profit from an overvalued market, as it bets on the market decline. However, shorting is also very risky, as it involves borrowing the security, paying interest and fees, and facing unlimited losses if the market rises instead of falls. Shorting is not recommended for novice or long-term investors, as it requires a high level of skill, knowledge, and discipline.

Timing the Market vs. Time in the Market

Some investors may be tempted to time the market, which is the act of moving money in or out of the market based on predictive methods, such as fundamental, technical, or economic analysis. The goal of timing the market is to buy low and sell high, and avoid the market downturns and capture the market upturns. However, timing the market is very difficult, if not impossible, to do consistently and accurately, as it requires predicting the future, which is uncertain and unpredictable.

Many studies have shown that timing the market can be detrimental to long-term returns, as it can cause investors to miss the best days in the market, which often occur during or after the worst days. For example, according to a study by JP Morgan, a $10,000 investment in the S&P 500 between January 1, 2003 and December 30, 2022 would have grown to $64,844 if the investor stayed invested for all days. However, if the investor missed the 10 best days in the market, the investment would have shrunk to $29,7082.

Therefore, instead of timing the market, investors may be better off staying in the market for the long term, and taking advantage of the power of compounding, which is the process of earning returns on returns. By staying in the market, investors can benefit from the long-term upward trend of the market, and smooth out the short-term fluctuations and volatility.

Basically, the stock market may be overvalued by some measures, but that does not mean that it will crash anytime soon. The market can remain overvalued for a long time, or even become more overvalued, as there are many factors that can influence the market price, such as interest rates, fiscal stimulus, earnings recovery, and emotional trading. Investing in an overvalued market can be challenging, but not impossible, if investors follow some strategies, such as diversifying, rebalancing, setting stop-loss orders, and considering shorting for experienced investors. However, the best strategy may be to avoid timing the market, and focus on time in the market, as history has shown that staying invested for the long term can generate competitive returns, regardless of market valuation.

Before looking to jump into the market and begin investing, we would highly suggest to talk to a professional financial adviser or coach that can help you to make the right decision for you and your long term goals.

Until Next Time,

Take Back Control

Risk versus Reward: How to Balance Your Portfolio for Long-Term Success

Investing is all about the future, but having a solid understanding of the history of markets can provide clarity and confidence when dealing with uncertainty. One of the most important concepts in investing is the relationship between risk and reward, which measures how much return you can expect for taking on a certain level of risk.

In general, the higher the risk, the higher the potential reward, but also the higher the chance of losing money. Conversely, the lower the risk, the lower the potential reward, but also the lower the chance of losing money. However, risk and reward are not always proportional, and different asset classes can have different risk-reward profiles over time.

Historical Returns by Asset Class

One way to compare the risk and reward of different asset classes is to look at their historical returns over a long period of time. For example, the following table shows the annualized returns and standard deviations of several asset classes from 1985 to 2019. You can check out the Vanguard Asset Class tool to check out data from 1970 through to 2022 here.

Historical Returns by Asset Class - 35 years (1985-2019)

Data for the graph above on 34 years of returns and volatility for each asset class.

As you can see, stocks have historically delivered the highest returns, but also the highest volatility, among the asset classes. Bonds have offered lower returns, but also lower volatility, than stocks. Cash has provided the lowest returns, but also the lowest volatility, among the asset classes. Gold has been a volatile asset class, with returns that have varied significantly over time. REITs have been a relatively high-returning and high-volatility asset class, reflecting the cyclical nature of the real estate market.

However, these historical averages do not tell the whole story. The returns and risks of each asset class can vary significantly from year to year, depending on the economic and market conditions.

There is no clear pattern or ranking of the asset classes over time. Some years, stocks outperform bonds, cash, gold, and REITs, while other years, the opposite is true. Some years, emerging markets lead the pack, while other years, they lag behind. Some years, gold shines as a safe haven, while other years, it loses its lustre. Some years, REITs boom as property prices soar, while other years, they bust as property prices collapse.

How to Manage Risk and Reward in Your Portfolio

So, how can you use this information to balance your portfolio for long-term success? Here are some tips and strategies to consider:

• Know your risk tolerance and return objectives over a time horizon. Before you invest, you should have a clear idea of how much risk you are willing and able to take, and how much return you need or want to achieve your financial goals based on a time period. Your risk tolerance and return objectives may depend on factors such as your age, income, expenses, savings, time horizon, and personality. You should also review your risk tolerance and return objectives periodically, as they may change over time.

• Diversify across asset classes, sectors, geographies, and styles. One of the most effective ways to reduce your portfolio risk and increase your portfolio reward is to diversify your investments across different asset classes, sectors, geographies, and styles. By doing so, you can reduce the impact of any single asset class, sector, geography, or style on your portfolio performance, and benefit from the different sources of return that each one offers. For example, you can invest in a mix of stocks, bonds, cash, gold, and REITs, as well as in different industries, countries, and market segments, such as value, growth, and quality.

• Adopt a long-term perspective and a disciplined approach. Investing is a marathon, not a sprint. You should focus on the long-term performance of your portfolio, rather than the short-term fluctuations of the market. You should also follow a disciplined approach to investing, such as using a buy-and-hold strategy, a dollar-cost averaging strategy, or a rebalancing strategy, to avoid emotional or impulsive decisions that may hurt your portfolio performance. By doing so, you can take advantage of the power of compounding, which can significantly enhance your portfolio returns over time.

• Seek professional advice. Investing can be complex and challenging, especially in uncertain and volatile times. You may benefit from seeking professional advice from a qualified financial planner, who can help you design and implement a portfolio that suits your risk tolerance and return objectives, as well as provide ongoing guidance and support.

In summary, risk and reward are two sides of the same coin in investing. You cannot have one without the other. However, you can manage your risk and reward by understanding the historical performance of different asset classes, diversifying your portfolio, adopting a long-term perspective and a disciplined approach, and seeking professional advice. By doing so, you can balance your portfolio for long-term success.

How to Choose the Right Investing Vehicle for You!

Getting ahead of the curve is not easy, it requires will power, discipline and a plan to execute. With the last two articles, I have delved into the most essential part, which comes down to paying yourself first and minimising your tax through understanding the tax system.

Finally, it comes down to where can you put your money that you have saved on tax and paid yourself first?

What is the best assets that will serve you over the next 10-30 years? To help you make your money work for you, rather than working for money…

Let’s list out the options, starting from conservative to more risky;

1. Savings accounts and term deposits

2. Bonds and loans

3. Commodities/National Currencies (Gold, USD, oil, silver, copper, etc.)

4. Real Estate/Property

5. Shares in a company or Stocks

6. Cryptocurrencies

Every asset or investment vehicle is just that, a vehicle to help you where you want to go. Therefore, it pays to understand where you want to go first. To help with that, I would highly suggest having a read of one of my first ever blog articles here.

Now you have created a location, an end point, a dream to achieve, lets look at the advantages and disadvantages of each asset class and investment vehicle.

Starting with Savings Accounts and Term Deposits…

Advantages

• Minimal risk, you will not lose any money

• Will get paid interest, depending on the bank and features

• Can lock in an interest rate for a specific time-frame if you have a term deposit (Great for when rates are decreasing)

Disadvantages

• Potential to lose value on your cash, for an example, right now inflation is 5.2% and the max interest you can earn is 2.60% (ING current rate as of 12th of July) on a standard savings account. Meaning you will actually be losing 2.6% of purchasing power and value on your cash by just sitting it in a savings account.

• If locked into a term deposit, not having the option to pull out cash quickly without potential for paying fees etc.

• Could potentially lose access to all of your cash if there is a liquidity crunch in the markets, whereby banks lose the ability to pay deposits. (A real fear back in the Global Financial Crisis. In Australia, $250,000 is guaranteed by majority of banks thanks to the government)

Bonds and Loans…

Advantages

• Greater returns than savings accounts

• Mostly guaranteed payments with a locked in rate (Corporate bonds can be more risky, but with a greater return potential)

• Minimal risk, much like a savings account, especially in Treasury Bonds (A loan to the government)

Disadvantages

• Difficult for retail investors like you or I to invest in individual bonds, therefore you need to look into bond funds.

• Bonds can be complex and can be quite price sensitive to interest rate hikes or decreases.

• Can also be sensitive to market sentiment, as seen by the increases in bond markets recently, whereby the markets are betting on higher rates.

Commodities/National Currencies…

Advantages

• Generally seen as an inflation hedge (Although national currencies are quite often weaker as inflation increases generally)

• When inflation is high, we start to see that commodity prices increase.

• Can be lower risk than shares, due to the price stability compared to listed companies.

Disadvantages

• Offers no actual value or payments other than the price, therefore your hopes ride on the price increasing.

• Can be more risky and more volatile depending on market sentiment at the time, as well as the global environment and a big emphasis on supply and demand (Economics).

• Can be fairly illiquid and difficult to sell, depending on how you buy (For eg; if you buy solid gold bars etc.)

Real Estate and Property

Advantages

• Has been the greatest wealth builder in Australia over the last 30 years (But does not deliver the greatest returns on average per annum)

• Generally less risky compared to shares, but higher risk compared to Bonds and savings accounts.

• Can have great tax minimising benefits, especially for high income earners

• Gives you a roof over your head if buying a home to live in

Disadvantages

• Cost of maintenance and upkeep

• Interest rate risk, whereby increasing rates increases the cost of loan servicing/costs

• Very illiquid, as it can be difficult to sell and takes time to sell the house or commercial property.

• Especially right now, the cost of owning a home or investment property is quite high, with prices at all time highs.

• Taxes on buying property are quite high

Shares of a company, Listed Managed Funds, Exchange Traded Funds

Advantages

• Has the greatest average per annum rate of return over the last 100 years

• Very liquid, you can buy and sell very quickly most of the time

• You can use a dollar cost averaging technique, which has become really common over the last five years to hedge against the volatility of the markets. (A technique used over the long term, roughly 7-30 years)

• Improves the living standards of people through companies and firms being able to use capital to solve solutions

• Dividend payments can be paid out, especially amongst the blue chip (Big market cap) companies.

Disadvantages

• Prices can be highly volatile in the short term and therefore are high risk and highly susceptible to market sentiment, based especially on forecasting.

• Due to the asset being very liquid, can be vulnerable to behaviourial bias, whereby if market prices decrease, the fear of loss leads to selling at the low prices, creating a potential loss.

• Companies can go into admission and you can lose all of your money

• Brokerage fees (the fees paid for buying a share, ETF etc)

• Capital gains tax is set quite high

Cryptocurrencies

Advantages

• Over the last five years especially, there has been a major bull run on crypto assets, which has made a lot of people quite rich

• Fairly liquid, when market sentiment is high

• There are a lot of Crypto companies doing great work and offering very high interest on their coins

Disadvantages

• Very volatile, more high risk than most companies or stocks

• Has no real value, whereby payments are not made and regulation is very low

• Very susceptible to market sentiment, as shown quite recently, whereby bitcoin was seen at a high of $68k and is now below $20k at time of writing

• Can be illiquid if there is a run on the coin, much like actual cash from a bank, when people pull all of their actual cash out of the coin and the value goes to zero (losing all of your money)

All of the above is a very simple list of the advantages and disadvantages, which as you can see can be quite confronting, however if you have the risk appetite, you can see some great returns on the money you have worked so hard to save.

From here, you simply need to understand how you handle risk and the idea of losing money.

The more risk you can take on, the more likely you can attain greater benefit, however the more likely you are also to lose your money. Therefore, understanding your ability to handle risk will determine what asset class or investment vehicle is best suited to you!

To understand your ability to handle risk, I would advise that you enlist the help of a trusted Financial Advisor, who will be able to guide you through the complexities of choosing which asset class and investment vehicles will be best suited to your risk profile and goals.

Which leads to the end of our Getting Ahead of the Curve Series, hopefully you have been able to take something out of the series and I truly want to see that you can use some of what I have discussed to improve your ability to get ahead!

Until next time,

Take Back Control

Did You Know that You are an Investor Already?

Most people know that they get paid superannuation, however most people do not go beyond that. They don’t see it as their money, until they get to the age of 40-50 years old, which is a HUGE mistake!

Your superannuation is YOUR Money and it is really important you understand what you are doing with your money. It can be the difference of between an extra $50,000-200,000, or more even depending on your earnings, at retirement. Which I am sure would go a long way to being able to travel the world when you retire, if that is what you want to do.

Your Superannuation is your first investment, which started as soon as you got a job. As Living in Australia and working in Australia means legally your employer must pay your superannuation guarantee.

The minimum superannuation pay for each eligible employee is 10% of their ordinary time earnings (OTE). However, it's scheduled to progressively increase to 12% by 2025. - ATO (1)

Which means 10% of your income will go towards your super every year, so if you earn $100,000 before tax, you will have roughly $10,000 contributed to your superannuation. The best part, all super contributions made up to $27,500 is taxed at a smaller rate than your wages that get paid to your bank account.

Any contributions that are made are taxed at 15%, which is a lot less than the average 32-37% of your income that gets taxed, depending on how much you earn.

You not only save money by having super, but you also can make a lot of money from the returns your fund will get for managing your money.

Of course, you want to make sure that you have the right fund and the government has even provided a great website that will compare your current fund with up to four other funds that may get you better results down the track based on previous performance.

Check out the Your Super Comparison Tool here

The above comparison tool is great, however it does have some short-comings, which are due to the fact that it doesn’t filter funds based on ESG (Environmental Social Governance), therefore you don’t know where your money is going and if its ethical. As well as the fact it only compares based off of the previous 7 years of annual returns and the annual fees.

Which, in hindsight, if you are 20 or 30 years old, you want your money in a fund that has been able to perform well for much more than just seven years.

However, the tool is a great start to seeing whether your fund is performing well or not and can give you some good insight into how other funds are performing.

The main reason as to why you should not just choose the fund that is the best-performing from the Your-Super-Tool comes down to the fact that every person’s circumstances are very different and depending on your age, you may not want the highest performing fund. Generally speaking, the higher the annual returns, the more volatile the returns can be.

If you have only six years left to retirement and you are in a very aggressive fund, that may affect you significantly if the markets were to have a down-turn.

Hence why it is always best to speak to a professional advisor and work with one to set-up your superannuation.

I believe it is especially important for when you are younger as well, when you get to about 21-29 years old, you should be essentially starting your professional/trade career.

Which means your super contributions will be much higher from your employer than it was previously. There are a whole range of things that you need to figure out due to your increased super contributions that will possibly make you a lot more money than the general fund that your super fund will put you in.

Not to mention there is insurance within super as well, whereby that eats away at your retirement savings, but it may be the only way you can afford to get life insurance, TPD (Total Permanent Disability) and Income protection. Therefore, you want to know what insurance is going to suit you the best and how you may need it to change when you have a baby, build a house etc.

But it is all really hard to figure out all by yourself, which is why using an accredited Financial Planner is the way to go!!

There are so many things that can go wrong if you choose the wrong fund, but there are a few tools at least to get you started.

I hope this has helped and that brings us to the end of our beginner investors guide.

If you have found this guide valuable, I would love it if you shared all ten blogs with friends and family. The more the merrier, as I want to see each and every one of you learn to Take Back Control of your Life-Health-Wealth !

Until next time,

Take Back Control

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References:

1. https://www.ato.gov.au/business/super-for-employers/paying-super-contributions/how-much-super-to-pay/