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,
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