Investing in an Expensive Market

Stock market analysts are worried. US stocks are at an all-time high, with many declaring that we are witnessing a bubble. Investing in an expensive market poses an interesting dilemma.

If the bubble bursts, losses will be sharp and dramatic. On the other hand, prices are rising, and gains are there for the taking.

In a recent note, JP Morgan addressed this very problem. Their research into expensive markets provided some interesting analysis, namely that 80% of markets that crash severely eventually return to all-time highs.

The note suggested that while the dot-com boom eventually became delivered, specific markets like Japanese Nikkei have never recovered from their late 80s peak. As a result, they suggest that investors should buy, rather than avoid, bubbles.

When too many people passively invest, it can increase the prices of an already expensive market. Overbought index funds increase the cost of underlying stocks, decreasing market efficiency and allocating capital to the undeserving stocks.

Within index funds, well-performing stocks can drag the underperformers along with their momentum, resulting in overvalued shares.

In these times, active investing can triumph. When underperforming parts of the index are high, stock pickers can select underpriced equities that give more significant returns.

In the 12 years since the financial crisis, the US stock market has grown massively. The MSCI USA Index is up 641 per since March 9, 2009. By way of comparison, the MSCI World (excluding the USA) index increased by 246 per cent in the same timeframe. This pattern has continued since the pandemic.

By many metrics, such as the cyclically adjusted price-to-earnings, US stocks are overvalued. Much of the recent surge can be attributed to the economic stimulus from the US government and the Federal Reserve.

With many passive funds overexposed to stock that has grown with little relation to its earnings, the merits of active investment are clear.

Timing the market is tough. According to Duncan Lamont, Schroders’ head of risk and analytics, shifting out of stocks is a losing strategy. He notes that an aversion to high-priced stocks would have kept most investors out of the market over the last decade.

All of this has left many investors confused about how to proceed. The market is expensive and may yet crash, and with indexes seemingly overbought, the art of stock picking will return.

The inverse relationship with stock returns and earnings has traditionally spelt trouble in the past. Indeed, Warren Buffett warned that younger investors are in the process of learning some “very expensive lessons.”

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