With the stock market crashing in 2020, many expected that the market has entered a downturn or a bear market. However, the March panic didn’t last long and stocks bounced back quickly. This begs the question: Is the stock market overvalued?
At the close of March 2020, everyone was expecting a slowdown of the stock market coming. Besides 10 years of gains, there is the pandemic that closed businesses and left millions unemployed. Bearish speculation was expected for the overall stock market.
To everyone’s surprise, the panic didn’t last long. The federal reserve and the central banks worldwide freed up (ahum printed ahum) extra money to invest in the economy and upped the financial system again.
Now, the question arises: is the stock market overvalued this year? Is there is a bubble forming that we need to be on the lookout for? Is there a plunge or a financial crisis waiting to happen? We’re looking into the Buffett Indicator, which is the favorite market indicator of well-known investor Warren Buffett.
How Does Stock Valuation Work?
When you want to know whether stocks are overvalued or undervalued, many people look at the market capitalization to GDP ratio. The total market capitalization is the total value of all companies combined. This ratio essentially compares the value of the stock market with the total GDP.
If we look at the situation since the pandemic in early 2020, we see that GDP has fallen while the stock market has risen. Normally, when the GDP falls the stocks go in the same direction. These valuations are important in assessing the health of the current stock market.
There is massive unemployment, but the S&P 500 index and the NASDAQ stock exchange have recently set new all-time highs. With the S&P 500 climbing 55% since March, there is a disbalance between the real economy and the equities on the stock market. We can draw the quick conclusion that the stock market is overvalued.
In order for the ratio to restore to more normal levels, we need the economy to improve and the GDP to rise. It is difficult to say whether or not the ratio will be brought back to normal in a short-term period. One thing is for sure, a market correction is needed rather than an overall market decline.
The stock market is volatile in general. The current economic climate will further increase market volatility, making it more important to have a diversified portfolio. Do you want to maximize return? See what’s the best to invest in Large Cap vs Mid Cap vs Small Cap stocks.
[Related Read: Is Exness a Good Broker?]
What Other Factors Contribute To Overvaluation?
When researching whether the stock market is overvalued this year, there are other things to take into account than just the total stock market to GDP.
With the interest at record lows, there aren’t many good alternatives to the stock market. If you keep cash, you will be paid next to nothing. If you keep bonds, these are also at historic lows. You could invest in gold and silver, but these have already increased over the last few months.
The Fed has reduced interest rates significantly and will keep them low for the upcoming period. These low interest rates force investors to invest in the stock market.
What About The Price-To-Earnings Ratio?
If we are looking for other indicators that the stock market is overvalued, the Shiller price-to-earnings ratio is a good place to start. At the time of writing (September 2020), the S&P 500 trades at almost 28.7 times projected earnings. It is the highest price-earnings ratio since May 2009.
With the price-to-earnings ratio being 15.4 historically over the period of 10 years, the stocks are trading for more than that.
How To Prepare Your Portfolio For An Overvalued Stock Market?
When you are investing in the stock market, it means that you don’t need your money in the near future. If you need your money within 5-10 years, many suggest that you keep it in high yield savings account instead of investing it. Why? Simply to prevent that you are selling at market lows. Instead of trading during weakness in the market-price, traders wait until valuations are in a much better condition.
In times of an overvalued stock market, it may be good to pay attention to dividend stocks. In general, dividend stocks are more attractive in bear markets or a recession, since their dividend can party offset any potential losses.
Besides that, it may be wise to look at which sectors are benefiting from the pandemic and which sectors are likely to be hit hard. I work in the hotel industry at the moment, which means I need to diversify my investments to other industries to offset that.
Also, it may be wise to diversify your investments in other assets. Assets that are not or little correlated to the stock market may be an interesting investment. We’re aiming for commodities, precious metals, or bonds. Diversifying your investments will help lower your risk and make sure you sleep better at night.
Whether we are heading to a V-shaped or W-shaped recovery is hard to say at this moment. It is important that you have a portfolio you feel comfortable with. If you feel like you’re taking too much risk at this moment, now is the time to rebalance your portfolio. Just be aware that lower risk can result in lower returns in your portfolio.
As always, time in the market beats timing the market.
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Diversifying Your Income Streams
When you want to diversify your income streams, it may be good to start a side hustle. Do you want to know more about best side hustles? Here are want to make extra money:
- Under the table jobs where you can get paid in cash if you need money now
- Starting a blog to write about your passions and make money
- Swagbucks – make money by completing surveys, watching videos, or getting cashback. Get $5 free when you’ve earned points. Read our entire Swagbucks review here.
- Inbox Dollars – free $5 sign up bonus. Make money by watching videos, shopping online, or completing surveys.
- Acorns – get a $5 bonus when you sign up to invest your change.
- Rakuten – get $10 free when you’ve earned $25 cash back by shopping online.
- Get cashback or sign up bonuses on peer-to-peer lending platforms.
In addition, tracking your income through Personal Capital is highly recommended. Why?
- Personal Capital is free to use
- You can link your bank account to track every dollar
- It includes a free net worth tracker
Conclusion – Is The Stock Market Overvalued?
If you’re wondering if now is a good time to invest, it is always a good time to start investing in the stock market. The stock market isn’t scary or extremely dangerous, as many believe. Many investors show exuberance towards stock market predictions. Fundamental analysis is needed instead of irrational management portfolios.
It is, however, important that you know how you can diversify when the stock market is overvalued. For example, it would be a good thing to look into low-cost index funds or ways of earning passive income. Diversification is an effective strategy rather than putting all your eggs in one basket.
Optimism in economies and major stock-market news is a good metric that the current stock market is normal. But a good trader knows that a good investment strategy knowing when the market is bullish or bearish and that the stock market is cyclical and speculative, so everyone is encouraged to exercise caution and vigilance. It’s a wild ride so expect the worst but hope for the best.