Lately, I’ve been hearing a lot of pundits saying the stock market is “overvalued.” I have no idea whether they’re correct or not, but fortunately, it doesn’t matter. Discussions of market “valuation” are completely irrelevant because they don’t provide any practical information that investors can turn into a successful investment strategy.
The idea of valuing the stock market relative to some sort of metric (price to earnings ratio is probably the most widely mentioned) appeals to common sense. It seems to make intuitive sense that when valuations are high and the market is relatively “expensive,” stock returns would be lower going forward. The problem is, that is often not the case. Even if market valuations are “high” (whatever that means), they can stay that way for a very long time, or even increase!
After all, that’s exactly what happened in the 1990’s. In the mid 90’s valuation metrics were well above historical averages and financial gurus everywhere were warning investors to be cautious. Federal Reserve chairman Alan Greenspan even got in on the action and made his famous “irrational exuberance” speech in December of 1996. The market continued to rally for over 3 years following his speech before reaching its peak in March of 2000; over that time the S&P 500 more than doubled*. If you followed the “experts” advice by selling stocks at that time, you would have missed one of the best bull markets in the history of the United States.
The market very well may be overvalued, but so what if it is? What are investors supposed to do with that information? NOTHING. No matter what the current market valuation is, investors are best served by staying invested in a diversified portfolio that has historically delivered the returns they need to fund their financial goals.
*Past performance is no indication of future results.