Buying in an Overvalued Market

With the DOW and S&P 500 hitting record highs this week, it’s logical to believe that US public equity markets are overvalued. Although global markets took a substantial hit following Brexit, they rebounded strongly, nearly 15% across some industries (as I forecasted). It remains clear that while Brexit has restrictive implications on trade regulations, the market overreacted to the decision in extreme fashion, and has since realized its irrationality.

Thus prompts the question: how do you invest in a seemingly overvalued market? Investing 101 suggests buy low, sell high, so how can you buy high and still win? I will outline one strategy below:

Consider the Price-to-Book ratio: The P/B ratio is calculated by dividing the price of the stock by the book value of the company. If a company has a P/B above 1, the market values the company above its book value, and if the P/B is below 1, the market values the company below its book value. This metric is important because it gives a simple starting place to formulate a valuation opinion. However, nearly all of investing is outsmarting the market sentiment, and this notion applies to the P/B as well: companies trade with a certain P/B as a result of the market’s expectation for a company. For example, Amazon trades at a P/B of 25. This means that the stock price values the company at twenty-five times its book value on paper (!). While this may seem outrageous, it could make sense for two reasons: 1) Investors believe Amazon has tremendous potential to grow (as I do), and thus justifiably value the company far above its paper value. 2) A typical P/B varies by industry. Companies in the tech/ecommerce industry have high P/Bs to begin with, and while 25 is high, Amazon’s industry average is 12. The average banking P/B is 1.1. Consider the P/B on a relative basis, with perspective to the respective industry.

However, take the P/B with a grain of salt: Barclays currently holds a P/B of .4, and while that is far below its industry average, it is .4 for a reason. The market is pessimistic regarding Barclays’ growth potential. Barclays is valued significantly below its book, and this valuation is justified; the company will face challenges as it moves forward in a post-brexit world. A low P/B may imply undervaluation, which may suggest a buy, but not always. The P/B should always be one of many pieces of information considered in an investment decision.

Although the P/B may be useful in picking a stock in an overvalued setting, there is a broader trend to consider: the market will slump. I wrote this post exploring the intriguing idea to buy in an expensive market, but a costly market usually suggests a coming correction. I would not discount a 15-20% hit to the market in the next 9 months. FED rates will likely remain near zero until Q1 ’17. The market is always volatile preceding elections, as uncertainty pervades. I would not suggest going long in the US public equities markets, unless you see particularly good value, as potentially conceived from the P/B ratio.

 

Bull

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