When stocks are on a winning streak, investors reap the rewards, but climbing prices often trigger mounting anxiety. And prices have been reaching skyward for some time now. In a recent survey from Bank of America and Merrill Lynch, 44 percent of fund managers say equities are too expensive. By region, a net 84 percent of fund managers say the U.S. is the most overvalued.
Worries about stock prices may be magnified for individual investors, but they should put this in perspective with the larger economy, says Ron Weiner, managing director and partner of RDM Financial Group at HighTower in Westport, Connecticut. “Right now, economic fundamentals remain mostly positive,” he says, citing a double-digit rise in earnings, steady job growth, a stable inflation rate and consistent levels of consumer and business confidence. For fears about overvaluation to be realized, economic conditions need to reverse direction first. Unfortunately, predicting when a bull market will turn into a bear market isn’t an exact science.
[See: 13 Ways to Take the Emotions Out of Investing.]
Matthew Peck, a certified financial planner and co-founder of SHP Financial in Plymouth, Massachusetts, says there are many different ways to forecast when an overvalued market is reaching its tipping point. The price-earnings ratio of the Standard and Poor’s 500 index is one. Yield curve is another.
The yield curve illustrates bond yield trends over varying maturities. A normal yield curve has higher interest rates for long-term bonds and lower ones for short-term bonds. Peck says that when the yield curve flattens, “that can be a sign that there’s a credit crunch and a recession may soon follow.”
For investors, an overvalued market begins to sting when it experiences a significant extended downturn, versus occasional dips. Knowing how to insulate your portfolio against major swings can quell fears about investing when stocks are on the rise.
You may be worrying about the wrong thing. Start by reviewing the fundamentals of your investments. This includes the return on equity, price-earnings multiples and growth rates for the last three years, says Rod Holloway, equity portfolio manager of Comprehensive Financial Consultants in Bloomington, Indiana.
He warns, however, not to rely on these metrics alone as that can create a false sense of security. Holloway says that even when the fundamentals look good, you should still check how far above certain key moving averages a stock is trading. This, he says, is a good way to determine if you have a short-term overvaluation.
Looking at historical data can also help you identify overvalued investments in your portfolio. Anthony Saglimbene, an Ameriprise Financial global market strategist based in the greater Detroit area, says a good rule of thumb is to look at valuations over multiple trailing periods and over full market cycles. He says overvalued investments may identify themselves by “exhibiting outsize price gains in relation to their fundamentals and overall business conditions.”
Although stocks may garner most of your attention, don’t overlook overvaluation with your other investments. John Traynor, executive vice president and chief investment officer at People’s United Wealth Management in Bridgeport, Connecticut, says bonds may be more overvalued than equities right now.
“We compare equities and bonds to several benchmarks over the last few market cycles, and while equities are expensive, we believe bonds are in rare territory with such low yields, relative to economic growth and inflation,” Traynor says. Bonds may be a bigger cause for concern than stocks, especially if the Federal Reserve continues raising rates.
Your most valuable asset is time. If you’ve identified some potentially overvalued segments of your portfolio, don’t panic. Instead, consider your overall investing strategy and how long you have to ride out a market downturn.
[See: 10 Long-Term Investing Strategies That Work.]
Ultimately, your investment goals will determine the time horizon, says Rusty Vanneman, chief investment officer for CLS Investments in Omaha, Nebraska. If your long-term investment plan is built according to your goals and risk tolerance, you may be better off ignoring the overvalued market and do nothing. “The markets are inherently volatile, but there’s a strong tendency to produce positive returns, more so than playing it safe in cash,” Vanneman says. If the market has you on edge, keeping some of your investments in cash can be a good defensive measure, but it doesn’t make sense to abandon stocks completely.
In fact, overvaluations could be a good thing if you have a longer window to invest. David Hays, president and founder of Comprehensive Financial Consultants, says time is an investor’s most valuable asset. If you have 30 years to retirement, a market correction can be a boon because you can buy stocks on sale. The problem is that too few investors take advantage of the price drop.
People love to stock up on supplies when the grocery store has a sale, Hays says, but when stocks are cheap, investors do just the opposite. They get cold feet and end up missing the boat even though that’s the best time to buy, he says.
A dispassionate assessment of whether your current asset allocation is designed to meet your needs can prevent fear-driven decision-making during periods of overvaluation. “Human emotion is a powerful thing when it comes to investing and financial markets,” Weiner says. An asset allocation that matches your goals can limit the potential fallout from a correction.
Every portfolio needs pruning. In an unstable market, a balanced portfolio is critical. Peck says that rebalancing regularly helps you cull overvalued assets from a portfolio. He recommends selling winners and buying losers quarterly to maintain the right mix of investments.
Looking beyond domestic stocks and diversifying with international stocks is also an option. Vanneman says that in a bull market, international stocks may be cheaper by comparison, thought they may also be more volatile. If so, increasing your exposure to fixed-income investments could balance out some of the risk.
[See: 9 Ways to Invest in America With Bond Funds.]
Just don’t try to time the market if you’re rebalancing when valuations are high. Consistency may be the hobgoblin of little minds, but it usually pays off with investments. “A successful investor sets a plan, periodically reviews their plan and most importantly, sticks to their plan,” Traynor says.
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How to Invest in an Overvalued Market originally appeared on usnews.com
