After a historic year – and decade – investors still have plenty of good reasons for optimism. A strong economy, record profits, historically low-interest rates. But, knowing what we know, the light may be changing from green to yellow, meaning proceed with caution.
It’s a new year, and, as the S&P 500 continues to chug to record highs, investors have plenty of reasons to cheer. The economy is picking up steam, the job market has never been stronger, corporate profitability is at historically high levels, and interest rates remain low with no perceivable signs of inflation – a heaven-like state from an investor’s perspective.
So why aren’t investors cheering?
Are You Still Getting What You Pay For?
Everyone knows that sinking feeling when you think you’ve paid too much for something. When you invest in the stock market, you are essentially investing in corporate profits – which are abundant these days. The question is, how much are you paying for those profits? Consider this: The DJIA has gained 11,000 points in a little over three years, which has never happened before.
That’s not to say the market can’t go higher – it almost certainly will. But what are you getting for what you’re paying?
Corporate profits may be at their historic highs but, by all measures, so are corporate valuations. That’s what happens with an 11,000 point gain in the market. Corporate profits drive stock market gains, but stock market gains drive corporate valuations, which are also historically high and, the more you pay for something, the higher the risk you’ve overpaid.
It’s Not Whether You Invest in the Market, It’s Where You Invest
More than ten years into an unprecedented bull market, investors are right to be skittish about continuing to invest in the stock market. At these heights, it’s okay to be concerned. But I contend the question is not whether to invest in the market; instead, it’s where in the market should I invest?
The number one question investors ask me these days is whether this is the right time to be investing in the market, and my response is always the same: I don’t invest in the market. I know that sounds glib, and most people don’t understand that answer coming from a professional investor. But it’s true. I don’t invest in the market; I invest in individual companies. That’s how investors can gain some degree of a footing to protect against an overvalued market by buying into industries or companies without overpaying for what you are getting. By investing in individual companies rather than the market as a whole, thoughtful investors can find pockets of opportunity in which the fundamentals and valuations work in their favor.
Why Investing in the Market is Riskier than Investing in Individual Stocks
The game-changing investment trend over the last decade has been the massive pivot toward index investing. In the early stages of the stock market recovery, active fund managers struggled to outperform the stock indexes, so investors figured out they could do better with their money by investing in low-cost index funds. And indeed, they did do better, riding the wave of relentless stock market gains even to this day.
While index investing has transformed the investing landscape, it has also transformed valuations, which is actually increasing the risk for investors. For example, the S&P 500 is a weighted index, which means the largest companies are over-weighted in the index. So, as more money flows into an S&P 500 index fund, the fund manager has to allocate it according to the index weightings, pushing the valuations of these large stocks even higher. As a result, the top ten companies in the S&P 500 index now drive 90% of its performance. So, if you invest in an S&P 500 index fund, you are, in essence, investing primarily in those ten stocks.
The problem with owning these ten stocks in an index fund is you have no risk control – no way to control your exposure to overvalued stocks – leaving you completely vulnerable to the downside. And there will be a downside someday.
Opportunities Abound But Proceed With Caution
Again, not saying the market can’t go significantly higher. It will, at least over time. I’m just saying that, after a more than 20,000-point gain in the DJIA over ten years, the green light may be changing to yellow –meaning, proceed with caution. It’s a far different market than it was ten years ago – even three years ago. It may be time to think about disconnecting yourself from the average and start looking at subsets of industries or companies that are not overpriced or overleveraged. There are still plenty of companies – well-managed and well-positioned for growth – that are not fully or fairly valued.
Through direct stock ownership in undervalued companies, you regain control of the amount of risk and volatility in your portfolio while enjoying all of the upside. It does require extensive research and fundamental analysis, which can be DIY or with the help of an experienced professional investor. And it does require patience and discipline to stick with your strategy. But you’re investing in a strategy designed specifically for you and your objectives, not thousands of other investors who may not know what they really own.