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What to Do in an Overvalued Market

by Q.ai Team

“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. The coronavirus pandemic slowed the growth temporarily, but many stocks are now in a better position than they were a year ago. Overvaluation seems to keep on climbing, and when – or whether – this apparent bubble will burst is anybody’s guess.

So, what’s a savvy investor to do about it?

Image Credit: Image by Tumisu from Pixabay 

What Does it Mean When a Market is Considered “Overvalued”?

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.

Measuring an Overvalued Market

Measuring a single stock’s overvaluation is fairly simple. Measuring the entire market, however, can take some wrangling.

One of the easiest ways is to measure the performance of a large index, such as the S&P 500 or the Nasdaq, as a surrogate for the entire U.S. market. Certainly, they don’t include every stock on the market, but they can provide a fair indicator of how a significant segment performs. And once you apply an indicator, such as the P/E ratio or the Q ratio, you can compare current performance against past data or future projects to determine the valuation of the market at large.

Measuring Stock Valuation with P/E Ratios

P/E ratios are a particularly useful measurement of valuation, and they’re the primary formula we’re going to focus on here. This number is calculated by dividing a company’s stock price by its earnings-per-share (EPS), often over a particular period of time. (For instance, in our Forbes articles, we often project forward 12-month P/E ratios.)

Once you have a P/E ratio in hand, you can determine a company’s valuation against competitors, the industry, and the market. Typically, a P/E ratio around 15 is considered “reasonable.” A lower ratio suggests a better buy, while a higher ratio may point to a stock that’s getting too expensive for its britches.

However, making this call involves wading through a sea of nuances. For instance, as of this writing, Amazon has a P/E ratio of 73.96. While this is an extraordinarily high valuation, it’s also to be expected, given Amazon’s outsize influence throughout the pandemic. Netflix, too, is sitting pretty at a P/E of 85.06 – again, firmly entrenched in overvaluation territory, but not unprecedented.

On the other hand, we have NortonLifeLock stumbling along at 4.23, and Xerox trending barely higher at 5.60. Looking at these numbers, they could both suggest a great buy for long-term gains. But where NortonLifeLock may become more useful as society reopens, paper and printing services are increasingly falling out of favor.

Of course, because every company (and industry) carries such nuances, it’s best to take P/E ratios on a case-by-case basis…unless you’re looking at market valuation.

Measuring Market Valuation with P/E Ratios

P/E ratios work similarly for the overall market: you add up the share price of every stock in the index or market of interest, then divide that by the sum of all relevant EPS. (Or you could google “[Index] P/E ratio” like we did here.)

As of the time of this writing:

  • The large-cap S&P 500 index sits at a P/E ratio of 35.7
  • Tech-dominated Nasdaq hovers around 23.47
  • Blue-chip king DJIA (Dow Jones Industrial Average) is at 33.59

While the Nasdaq’s valuation is certainly above middling, it’s on the edge of overvalued, rather than firmly entrenched. This indicates that many tech stocks fall between moderate and overvaluation, though there are certainly outliers. (Netflix, anyone?)

However, both the S&P 500 and the DJIA rest squarely in overvaluation territory – suggesting that, at least as far as large-cap companies go, the market is overvalued.

A 70-year history of S&P 500 P/E averages

Image Credit: Screenshot from currentmarketvaluation.com

Other Ways to Measure Market Valuation

Of course, the basic P/E ratio is nuanced and limited. Thus, you may want to use a combination of altered P/E ratios and other metrics to gain a broader picture.

For instance, the website Advisor Perspectives uses four market valuation indicators to examine the market. Two of these – the Crestmont Research P/E Ratio and the trailing 10-year cyclical P/E ratio – rely on variations of the P/E formula. They also use the Q Ratio, or the total market price divided by replacement cost, as well as the S&P Composite’s relationship to a regression trendline.

By compiling these four metrics, Advisor Perspectives paints a broader picture of market valuation. This provides a more complex framework for understanding the market. While we won’t go into more detail here, you can see the outcome of comparing these metrics in their comprehensive chart:

Image Credit: Screenshot from advisorperspectives.com

Causes of 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 Emotion

One of the most direct causes of overvaluation in the short-term is investors artificially inflating the market by acting on emotional responses. For example, these illogical, irrational decisions made en masse may stem from:

  • Seeing other investors pile on a particular stock
  • Response to a piece of corporate news, such as a quarterly report
  • A Reddit account that encourages investors to stock up on worthless securities

Economic Activity

But investor emotions are far from the only path to overvaluation. For instance, periods of economic turmoil may lead to companies experiencing deterioration in their fundamentals or balance sheets. On paper, this may lead to overvalued stocks according to their P/E ratios.

The coronavirus pandemic is a perfect example. Most investors and laypeople are at least vaguely aware of the pandemic’s impact on the U.S. stock market: when bad news struck, businesses and investors lost millions overnight. Many businesses struggled afterward, while some leapt up in spite of poor economic performance. A large number claimed write-offs that led to depressed earnings and high P/E ratios.

As a result, some reasonably valued companies became overvalued through no intentional action of their own. The impacts ripple in the market even today – this is one of the reasons that blue-chip stocks and the S&P 500 are both overvalued. (By contrast, the Nasdaq Index is comprised of tech stocks that are both doing well and trading high, which leads to lower P/E ratios. This indicates less overvaluation and more appropriately aggressive growth.)

Value Traps

There is another kind of overvaluation that come about in due course: value traps. These occur when companies in economy-reliant industries, such as car manufacturers and steel mills, become subject to the whims of economic cycles. As the economy suffers, these businesses may lose or stall in profits. Then, as the economy expands, they surge forward with higher earnings, bigger dividends, and…lower P/E ratios.

This can cause businesses and even entire sectors to appear undervalued as a result of their underlying financials. However, in practice they are reasonably or even overvalued, and may lead to losses. Unfortunately, young and inexperienced investors are more likely to fall prey to value traps than seasoned investors.

What Should Investors Do in an 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.

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.

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.

But Most of All, 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 – see everyone who made a profit buying the dip last March – 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.