How to invest in overvalued markets
I'm sure you have also recently seen a lot of articles telling you how expensive or overvalued markets are - comparing the current market valuation to the past.
For example like this chart:
Source: Schiller PE
What is the Schiller PE?
This chart shows you the Price earnings ratio of the S&P 500 based on average inflation-adjusted earnings from the previous 10 years. It is known as the Cyclically Adjusted PE Ratio (also known as the CAPE Ratio, Shiller PE Ratio, or PE 10).
As you can see only once has the market been more expensive than this and that was during the internet bubble – and we all know how that ended.
Will the market crash?
As you can imagine this high valuation brings with it a lot of speculation about a market crash - if it will take place and when.
Everybody of course has no idea as to when or if it will take place but it makes for a good article that pulls a lot of readers.
As you know I do not make market predictions so I also have no idea if or when a crash will take place – but that is not the point.
What is important to know now
What is important is how we should invest in the current market environment and what returns can we expect – if the market is already so expensive.
It is a good question that nobody really knows the answer to but here is something that can help us.
It is a chart published by one of the few asset managers you can trust.
Everything they publish is helpful and best of all it's completely free. All you have to do is go to www.GMO.com register for free and tick the box that you want to be notified of the future publications.
Returns for the next 7 years
For as long as I can remember GMO each month publishes a chart that shows you what seven year annual real (after inflation) return you can expect for a number of investments.
Because the returns are based on mean reversal (valuations tend to return to what they have been on average over long periods of time) they have been surprisingly accurate.
These are the returns GMO says we can look forward to over the next seven years:
Source: www.gmo.com (Free registration required) as of 31 July 2017
Nothing to get excited about
As you can see there's nothing to get excited about. US large company returns look horrible (-4.2%) with small companies not far behind.
The only asset that looks like it will give you a half decent return - but at 2.7% is not really exciting - is emerging market equities.
But do you want to invest in emerging markets for that small return compared to the risk? I don't know about you but I do not want take that much risk.
Let’s get back to the newsletter.
What about the newsletter?
As you know the newsletter has been avoiding expensive markets – mainly the USA but more recently Europe – for quite some time already.
That is why the cash part of these two newsletter portfolios is so high - in North America its 87% and in Europe 80%.
This is not that I want you to hold cash, it is because there are simply no undervalued good quality companies I could find to recommend to you.
The only place worth investing
The only bright spot where I have been able to find quite a lot of very undervalued companies for you is Asia, mainly Japan.
But like you, I do not want to invest my whole portfolio in Japan – 30% to 40% is what I am comfortable with.
Your level will be different and that is fine – as I have mentioned in the past the best portfolio for you is the one that lets you sleep comfortably every night.
So what does this all mean?
This is all very interesting but what should I do now, you may be thinking?
1. Avoid the US markets
If you have investments in the US market think seriously about reducing them.
In the newsletter, no new ideas, the selling of old ideas and the strict stop-loss system we follow will automatically reduce your investments there.
2. Be careful of Europe
Europe is not cheap any more, and the same as the USA, the cash part of this newsletter portfolio will also be increasing.
3. Asia is attractive
As I said Asia is the only market that is even mildly attractive at the moment.
Set a limit to the part of your portfolio you want to invest there – a limit you are comfortable with - there is no right or wrong answer here.
I am comfortable investing up to 40% in Asia. At the moment I have 22% of my portfolio there, mainly in Japan.
4. Don’t be afraid of cash
Don’t be afraid of holding cash, inflation is low and you will not be holding it forever.
Cash gives you the freedom to invest when other investors are selling at mad prices because they just want to get out – that makes it a very valuable asset even though it’s hard to hold when all the markets are moving up, as they are at the moment.
Wishing you profitable investing
PS This article was the editorial of September issue of the Quant Value newsletter. To get information like this on a monthly basis sign up here
PPS You can find more information on the newsletter here: About the Quant Value Newsletter.