With the stock market reaching all-time highs week after week, many expect that the market will enter a downturn or a bear market soon. This begs the question: Is the stock market overvalued?
Last year, the stock markets dipped for a couple of months before they continued to set all-time highs again.
The federal reserve and the central banks worldwide freed up extra money to invest in the economy and upped the financial system again. This made investors all the more confident in the market, and appropriate investments were made.
Now, the question arises: is the stock market overvalued this year? Is there a bubble forming that we need to be on the lookout for? Is there a global market plunge or a financial crisis waiting to happen? Is the market still on a bullish trend, or a bearish turn is coming?
We’re looking into the Buffett Indicator, the favorite market indicator of well-known investor Warren Buffett.
How Does Stock Valuation Work?
Many people look at the market capitalization to GDP ratio to know whether stocks are overvalued or undervalued. 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 early 2020, we see that GDP has fallen while the stock market has risen. Usually, 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 consider than just the total stock market to GDP.
With 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.
[Related Read: Get Over Your Fear Of The Stock Market & Start Investing]
What About The Price-To-Earnings Ratio?
If we look for other indicators that the stock market is overvalued, the Shiller price-to-earnings ratio is an excellent place to start. At the time of writing (August 2021), the S&P 500 trades at almost 38 times projected earnings. It is the highest price-earnings ratio since the dot-com bubble in 2000-2001.
With the price-to-earnings ratio being 15.4 historically over 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, you don’t need your money right away. If you need your money within 5-10 years, many suggest keeping it in high yield savings account instead of investing it.
Why? Simply to prevent you from 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 offset any potential losses.
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 attractive 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.
You must 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.
[Related Read: Stock Market Hours – What Time Does The Stock Market Open?]
Best Ways To Start Investing
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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 the 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. Try Bluehost and start your blog today!
- Swagbucks – make money by completing surveys, watching videos, or getting cash back. 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. Check our full InboxDollars review here.
- Acorns – get a $20 bonus when you sign up to invest your change.
- Rakuten – get $10 free when you’ve earned $25 cashback by shopping online. Read our full Rakuten review for more details.
- 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
[Related Read: Appreciating Assets – 23 Ways To Grow Your Wealth]
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 look at stock prices predictions. Fundamental analysis is needed instead of irrational management portfolios. Understanding the basics will help you lessen your fears and make you more interested and hopeful that this financial strategy is good for your overall financial plans. Panic and uncertainty have no place when investing in these emerging markets.
It is, however, important that you know how you can diversify when the stock market is overvalued. For example, it would be good 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. This is the mark of a true investor, as you should never lay 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 the stock market is cyclical, so everyone is encouraged to exercise caution and vigilance. It’s a wild ride so expect the worst but hope for the best.
Marjolein is a financial consultant who has built over €4,000 monthly passive income and saves over 70% of her income. Read Radicals’ inspiring story, from stuck in the 9-to-5 to loving life. Feel free to send Radical a message at the bottom of this page