3 Ways to Invest in an Overvalued Market
--- Updated 4/14/18 ---
Unless you've been hiding from the news over the past few months, you've probably caught wind that U.S. stock markets are at all-time highs. Not only this, but domestic stock markets seem to keep running to new highs nearly each week. This begs to question whether or not the market has run too far, and if so, what you can do to protect yourself in the event a correction is on the horizon.
First, let's take a quick look at the current valuation levels of U.S. markets:
The first chart shows the rise and fall of the S&P 500 (a good tape measure of pricing in the U.S. stock market) since 1995. As one can see, we've been in quite the extended bull market run since March 9th, 2009. According to the second chart, the price of the U.S. stock market (by measure of the Forward Price/Earnings ratio) is now at 16.4. This is relatively high ratio, but still a distance from the 24.5 measure we saw during the 1999/2000 tech bubble. By comparison, the average historical valuation since 1985 has been just over 15. This leads me to believe that the U.S. stock market is indeed overvalued, but not at overly extreme levels.
Although bull markets don't simply die due to high valuations (rather, it usually takes an unforeseen event to trigger a sustained market drop), it is prudent to start thinking of ways you can help protect both your investments and your mental health in the event a pullback does occur in the not so distant future. Avoiding complicated strategies, and instead focusing on smart and simple items that are actionable for the everyday investor, here are three ways you can take steps today to help preserve some of your hard earned money and avoid emotional stress.
1. Think International
This comes down to making sure your portfolio is properly diversified. While the U.S. stock market is presently overvalued due to its sustained run higher, most all equity markets abroad are either reasonably priced or flat out on sale versus their historical valuations. See the two charts here below:
From the same Forward Price/Earnings ratio we looked at for the U.S. stock market, developed markets (DM) internationally are currently trading at a ratio of 13.6, below their historical value of 16.3. These markets encompass developed countries such as Canada, Germany, Japan, and so forth. International emerging markets (EM) are trading at a ratio of 11.8, or right below their historical average of 12.3. This market category covers developing countries such as Brazil, China, India, etc.
All this being said, take a look at your portfolio and first see if you have any international equity exposure at all. If not, definitely make sure to add a position in your portfolio as there is a good chance these markets will outperform the U.S. over the near to mid-term. If you already have international equity exposure, now might be the time to tilt even more of your portfolio in that direction.
Know that international equities make up nearly half of world's stock market (as shown above). Don't be the one who succumbs to a home country bias, missing out on some exciting opportunities outside of U.S. borders.
2. Pocket Some Earnings
You will hear this from me time and time again: day-trading and market-timing are absolute losing strategies. These guessing games have proven to be detrimental to investor returns over nearly every historical measure or study I've seen (as referenced in this prior post). But that being said, there is no harm in trimming a portion of the overvalued section of your portfolio; especially if this will help you stay in the game as a prudent investor.
My primary function as an advisor is to help keep clients from making mistakes. If someone is on the fence about moving a portfolio entirely to cash (a mistake!), a conversation about shifting just a portion of their U.S. exposure to safe investments (cash or short-term bond holdings) for the time being is warranted. Moving 25% (or slightly more, depending on the client) of an overvalued sector of the market somewhere safe will not dramatically impact long-term investment performance, but it will likely help the nervous investor sleep better at night while not crippling their long-term financial objectives.
You can do this with your own portfolio if you are feeling entirely too much stress over your investments. Just make sure you establish a hard rule for when you will redeploy those funds; possibly after a preset and specific amount of time, or after you land that raise or new job that will enhance the whole of your financial picture.
3. Dollar-Cost Average
For those looking to begin investing a lump sum of money at these levels, your strategy should look a bit different from those that have had their money working throughout the entirety of this U.S. stock market rally. An investment strategy I love in this situation is a method of cash deployment called dollar-cost averaging.
Dollar-cost averaging is an investment technique of buying a fixed amount of a particular investment over a regular, pre-set schedule, regardless of stock price. For example, let's say you have $100k in cash and want to implement this strategy. You might decide to invest $10k over a 10 month time period until you are fully invested. This is dollar-cost averaging. The idea is that you are buying less shares per $10k purchase when stock prices are high and more shares per $10k purchase when stock prices are low. This slower approach helps people feel comfortable about moving into an uncertain marketplace (like your dog's thundershirt, but for human investors).
At today's valuations, I see no issue with a new investor buying fully into both their perspective bond (since movements there won't be as volatile) and international stock (since this sector likely has more potential to grow from here) allocations. However, for the U.S. stock portion of the portfolio, it might make most sense to implement a dollar-cost averaging strategy for investment. This helps ensure that not all money is thrown into the sector at once, risking a larger cumulative loss if a correction does rear its head in the very near-term.
Bottom line: If you are a disciplined buy-and-hold investor through all market conditions, I applaud you. However, please know that you are the minority! If you experience stress during market cycles like most of us do, I hope there is an actionable takeaway in one of these three items that will help you stay invested. It's not an easy road, even for me. Therefore, I also encourage you to try and embed yourself in a strong community of investors (either locally or online), follow the writings of level-headed investment professionals (Jonathan Clements and Ben Carlson are two of my favorites), and/or hire a prudent advisor that can support you along your journey. The path is much easier with fresh perspectives and knowledge to help you battle through.