When is the market overvalued?

As an investor you have a certain responsibility towards yourself as to not buy stock of overvalued companies.

Blue picture of declining stock index with text about overvalued markets

Where does that lead us today when the market on all metrics is overvalued? Do you sell your stock and miss out on the spectacular gains of the final blow-out phase or do you buy more on the assumption that there will always be a greater fool to whom you can sell if things go wrong?

It may seem as though we have left the old paradigms about value behind us, but at the same time we cannot seem to work out a new one either.

The first thing that we need to conclude is that past performance is a very poor guide for the future. Just because the market has been going up with 270 per cent since the depths of the financial crisis there is nothing guaranteeing that this will continue. If you believe this, you also believe that the market will continue up indefinitely, for ever, and that all the declines in the market are just temporary.

Now, it is obvious that if a company repeatedly is showing good financial results, they are likely to continue. That is because a good financial result over time equates to a certain business advantage or “edge” in the market in which it operates. Thus, a good financial result is likely to engender higher prices of the stock.

In fact, the opposite is true. The longer the market has advanced, the higher the probability of it crashing down eventually. We all know that sooner or later this is what happens when prices fall spectacularly.

The second point about an overvalued market is that it matters. The assumption that the price of the general market is irrelevant is wrong. That assumes that you always be able to find cheap, bargain stocks, no matter what the price level of the market is. That is obviously not true. There are times when the market is so highly priced that it’s a fool’s errand to look for cheap value stocks.

Most Wall Street pundits are talking about the advance of the market since the depths of the financial crisis, they don’t mention that those advances have been from extremely depressed levels. That is another reason not to expect the market to continue up.

Another way of looking at the valuation of today’s stock market is to say that the nature of bull runs and subsequent crashes has not changed. In fact this has been the pattern throughout history and there is little to argue for that this situation has changed.

There are many people talking about the current price level of the market who are concluding that the current price of the market is a direct consequence of low interest rates and global central bank policy.

There may be policies that indirectly affect the market, but in the long run the market is a weighing machine that is at least trying to get things right.

The mere idea that the market was undervalued in March of 2009 and is overvalued now tells me that the probability of huge price gyrations are great also in the future.

So this is the take home message: The likelihood of huge swings in the market is always there and it is due to human nature.

 

This article is very much inspired by the wisdom of legendary investor Benjamin Graham and a talk he gave in San Francisco in 1962.

 

 

 

Leave a Reply

Your email address will not be published.

Popular articles:

Guide to Technical Analysis


Guide to Value Investing


Using Microsoft Excel in finance


Subscribe to RSS

Business Blogs - The Blog Index

Follow me on Blogarama