Where to Invest in an Overvalued Stock Market?
The market crashed in 2008, more than 10 years ago and has been rising ever since.
This is awesome if you’ve participated in the climb.
But, there’s a problem, with assets climbing for 12 years, it’s tough to find decent and well valued investments.
Get 5 actionable investment ideas for a frothy overvalued stock market.
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5 Places to Invest in an Overvalued Stock Market
These 5 investment ideas will round out your portfolio until the overvalued stocks cool off and bargains re-emerge
Seeking investments that are fairly valued today is like looking for a needle in a haystack. After a 12+ year bull market, there are slim pickings in this frothy market. It reminds me of 1998, when I was looking for value stocks during the dot com boom. Everything was richly valued.
Fortunately, I didn’t go all in then, so was only modestly damaged by the horrendous S&P 500 losses of 9.03%, 11.85% and 21.97% during the bust years of 2000 through 2002.
Now, I’m not saying that we’re due for three losing years, but the future is unknowable. And, markets have periodic down years. Yet, running for the hills, going into all cash isn’t the solution either. After all, as economist John Maynard Keynes brilliantly said, “The market can stay irrational longer than you can stay solvent.”
Shiller PE Ratio
Is the Market Overvalued?
The U.S. stock market as represented by the S&P 500 is more richly valued than it has been since the turn of the century-that’s 21 years! The current Shiller PE ratio is 35.05 and the average ratio is 16.78. The Shiller PE or CAPE (cyclically adjusted price earnings ratio) is a price earnings ratio that divides the current price of a stock or index by the inflation-adjusted earnings from the previous 10 years. It’s a popular way to compare the valuation of stocks and indexes today with historical averages. Even with a dirth of underpriced stocks, you can still find some places to invest.
Notice that the current Shiller PE ratio is above the 2008 peak of approximately 28, but far below the 2000 peak of 44. Since 1970, the current Shiller PE ratio hasn’t been surpassed in any year except 2000.
Why you should be cautious?
Investing in overvalued stocks nearly guarantees that your returns going forward will be lower.
There are many research studies confirming that when PE ratios are high, future stock market returns are lower. In fact, the prestigious GMO research predicts low future returns for most asset classes except the international value stock category.
So, here’s where to invest in a frothy market.
1. Cash Investing
After years of near-zero interest rates, cash isn’t such a bad place to be anymore. If you’re skittish about the U.S. stock market valuation today, you can get paid to wait for fairer valuations by investing in cash.
Granted this is a capital preservation strategy, not a growth approach. Yet, sometimes cash preservation is a wise tactic, especially in a richly valued investment market.
So, the easiest cash investments are money market funds and CDs. Eschewed by investors, CDs aren’t so silly when stocks are overpriced. Even if you’re just treading water, you’ll be prepared to invest for higher returns after a market crash.
Typically, when investment markets are trading at stratospheric levels, think 1999, at some point stock prices will fall. Those who have extra cash can then pick up stocks and funds for much lower prices. When markets get frothy, I don’t mind holding out cash to redeploy when prices are lower.
This strategy has worked out well for me from 2000 to 2002, when the S&P 500 lost -9.03%, -11.85%, and -21.97%. Although our existing investments lost value, we also invested during these years as the S&P 500 rebounded for a 28.36% gain in 2003 and another 10.74% in 2004.
We did the same thing during the -36.55% S&P 500 crash of 2008.
So, don’t be afraid to hold cash, be patient, and wait for fairer investment valuations.
2. Bond Investing
You can buy individual bonds of varying quality and maturities to increase your fixed yield, and protect your portfolio from losses should stock prices decline.
You might consider an inflation protected ETF like the SPDR Portfolio TIPS ETF (SPIP), with a 12 month distribution yield of 1.97%. TIPS or treasury inflation protected securities are designed to protect your investment from the loss of purchasing power from inflation.
Following are two bond funds that are in my portfolio now:
VTEB – Vanguard tax-exempt municipal bond fund – This is in a taxable portfolio and offers tax-exempt income.
IBDO – iShares iBonds December 2023 Corporate ETF – This is a corporate bond fund with a maturity date of December, 2023. That way the principal value of the fund is protected, should interest rates rise. (When interest rates rise, bond values decline.)
You won’t make a killing in bonds today, but you also shouldn’t lose a lot. You might look at owning bonds today as a way to reduce your overall portfolio volatility.
Dogs of the Dow – December 2020
3. Dogs of the Dow
This strategy using Dow Jones stocks can be very effective.
There are countless investment strategies ranging from complex options tactics to simply buying an S&P 500 index fund. For investors seeking a “conservative-ish”, high dividend investment approach that’s likely to beat the S&P 500 and the Dow Jones Industrial Average and is easy to implement, consider the “Dogs of the Dow” approach.
The Dogs of the Dow are the ten highest yielding Dow Jones stocks. Proponents of this approach recommend buying these 10 stocks at the beginning of each year and selling them at the end, then repeat the process. This investment strategy has beat both the Dow and the S&P 500 most years since 2000.
Between 2000 and 2016, the Dogs of the Dow returned 8.6% annually, while the S&P 500 garnered 6.2%.
The concept behind this approach is that dividend yield, is a function of a low valued company.
The Dividend Yield = Annual Dividend/Share Price
The annual dividend is the amount of dividends that a company paid out annually.
The share price is the current trading price of a company’s stock.
The potential problem with this strategy is that there might be a serious problem with a low-valuation, high dividend stock. But, one might argue, that since the DOW is comprised of blue chip or high quality companies, that they are likely to appreciate over time, while investors enjoy the higher dividend yields. And, investing in the 10 highest dividend DOW stocks will provide a diversification ballast against poor returns of one or two stocks.
The Dogs of the DOW returns have bested those of the DOW and S&P 500:
Annual average return
Average annual return
|Dogs of the DOW||13.4%||15.9%||9.5%|
|S & P 500||12.5%||14.2%||7.7%|
|Dow Jones Industrial Average||13.3%||13.9%||8.4%|
To implement this strategy, just by an equal amount of the highest yielding DOW stocks and sell at the end of the year. Repeat again the following year.
4. Crowd Funding
Now might be the time to broaden your investing beyond just typical stocks and bonds. There are ways to tap into big real estate deals nand unique debt investing opportunities. Recently, many investment crowdfunding opportunities have popped up. But, it’s important to note that some platforms tie your money up for several years, so these are long term investments.
Diversyfund is a way to invest in real estate deals without the work. The company buys and renovates apartment buildings and you can invest for only $500.
Groundfloor is another real estate investment platform with a $10 minimum. Unlike Diversyfund, Groundfloor gives the small investor the opportunity to own part of a real estate mortgage and reports average 10% returns.
5. Developed and Emerging Markets Stocks
In their short and long term projections, State Street Global Advisors believe that emerging and developed market equities are poised to the best performers going forward. If we return to our valuation argument, it makes sense. With the US stock market overvalued according to PE metrics, the global investment markets might be the only regions to find value in the stock market. According to Siblis Research, as of December 2020, The trailing (prior 12 months) PE ratio for the developed world equities is 28.86, and 21.26 for emerging market stocks.
These regions have become a tad more expensive recently, due to the lack of bargains in the US markets.
You might consider an emerging market index ETF like the SPDR Portoflio Emerging Mkts ETF (SPEM) with a18.6 PD ratio and a 1.52 yield.
For a decent yield and low PE ratio, the iShares Core MSCI Europe ETF (IEUR) is an interesting developed market fund. With a PE ratio of 18.58 and an SEC yield of 1.92%, this fund holds more promise than many US based investments.
Where to Invest When the Market is High? – Wrap up
How do you gauge the true worth of a market like the S&P 500? Like individual stocks, the price paid for the market as a whole may be higher or lower than its actual value, and market valuation matters.
To maximize investment gains, you don’t want to overpay for stocks, whether it’s an individual company or an entire market index. A significantly overvalued stock market might even prompt you to take action, perhaps by selling some stocks and shifting more of your assets into cash or bonds.
But just because the stock market is overvalued, it it a reason to sell?
Not necessarily, says Ben Carlson, director of institutional asset management at Ritholtz Wealth Management in New York, in “What 8 Valuation Metrics Tell Us About the Market Now” an article I wrote for US News and World Report. Predicting exact peaks and valleys of a market is impossible. Use investment market valuations as a guide to future returns, not as a crystal ball.
Now is a good time to look abroad, diversify into less correlated asset classes like real estate, and even hold some cash. A contrarian approach, like the Dogs of the DOW will keep you invested while delivering cash flow.
As with all investing, don’t look at the stock and bond markets in the same way as holding your money in a bank money market account or certificate of deposit. Investing in financial markets is a wonderful long term way to build wealth, but you must have patience and understand what you’re investing in. And don’t be afraid to hold some cash. Markets fall, and when prices decline, it’s great to have some cash to deploy.
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Diversyfund Review – Real Estate Crowdfunding for Everyday Investors
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