What Is an Overvalued Market?
“The market” — for our purposes, the securities that comprise the U.S. trading economy — is an unwieldy beast. It’s made up of corporate stocks, government bonds, options, and a plethora of more complex securities. Due to its intricate nature, it’s hard to apply a blanket statement about all market movements.
But some terms can apply to most securities in the broader market. One of these that has come roaring back is that the market is overvalued. And it’s no surprise, either — the U.S. stock market has been trending up for the better part of a decade.
What is an overvalued market?
Most investors are familiar with overvalued stocks — stocks that are trading too high against the relative market or earnings outlooks. Overvaluation may indicate several things, but one thing is for sure more often than not: if the company doesn’t rise to the occasion, the stock will tumble back into reasonable territory instead.
The same is true of the U.S. investment market at large. When enough stocks become overvalued, either in an industry or across the board, prices inflate beyond the market’s worth. And when the market becomes overvalued, it can lead to real-world impacts on your portfolio.
What causes an overvalued market?
There are a variety of reasons a stock may drift into overvaluation. In turn, many of these extend to the market: if enough stocks or industries experience overvaluation, the market will sway, too.
But what causes an overvalued market in the first place?
- Investor emotions that can cause illogical, irrational decisions
- Economic activity like economic turmoil
- Value traps, such as when companies in economy-reliant industries (like car manufacturers and steel mills) become subject to the whims of economic cycles
What should you do in a overvalued market?
When the market is overvalued, there are a few ways you can approach your investing strategy. Ultimately, the best answer is one that includes thinking for the long-term, rather than how to improve your short-term gains. And of course, it’s prudent to keep your financial situation in mind, as well as your short- and long-term goals.
1. Focus on undervalued investments.
If you’re looking to cash in during an overvalued market, you might start with undervalued investments. Just because the market is overvalued doesn’t mean every sector is — just look at Nasdaq’s valuation against the S&P 500.
Of course, this strategy requires some foresight and faith. For instance, while oil and gas are currently undervalued, the push for green energy may eventually make this undervaluation a long-term reality. Buying these undervalued stocks now may not fit with a long-term investing plan, though it may potentially lead to short-term returns.
2. Balance your Portfolio with non-stock assets.
Another way to address an overvalued market is to look outside traditional securities. Bonds, mutual funds, ETFs, and commodities not only diversify your portfolio, but they provide protection against the inevitable drop in valuation. And if you’re feeling particularly adventurous, you can gaze beyond domestic borders to foreign securities.
If you’re looking for more complex assets, you may also consider investments such as trusts, REITs, Forex, traditional real estate holdings, or even options. However, these are not always beginner-friendly assets; as such, it’s important to do your due diligence or even enlist the services of a financial professional.
3. Stick to your plan.
Trying to time the market, beat the market, or otherwise outwit a non-living entity controlled by millions of rational and irrational minds at odds is, in and of itself, an irrational decision. While day-trading and market timing can sometimes lead to big payoffs, most of the time, they come out to average or even below-average returns once you account for taxes and fees.
So, instead of worrying about what the market is doing in overvaluation territory, stick to your investment plan. If you dollar-cost average by investing $100 every month, regardless of performance, keep at it. If you rebalance your portfolio every 12 weeks just in case, get ready to trim down or buff up accordingly.
As Warren Buffet can attest, the market rewards long-term investing strategies. Thus, holding your assets will likely net better returns than panicking over the market’s P/E ratio.
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