Highly Overvalued Market? Consider Employing These Strategies

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Includes: AGG, BND, VAW, VB, VGT, VHT, VMMXX, VNQ, VO, VOO, VOX, VPU, VTIBX, VWITX, VWO, VXUS
by: Tom Madell

Summary

When stocks/ETFs/funds become extremely overvalued, as they were in July 2014, it makes sense to change one's investing strategy.

Poor or negative returns may follow from overvalued stocks, but only after some lead time and often without much warning.

Stocks were as overvalued recently as they were in 2007; by three years later (2010), returns were universally poor, once again suggesting that overvaluation is a precursor of underperformance.

Asset allocations with a lightened position in overvalued ETFs/funds should have the potential to outperform over approximately the next 18 months.

tressure It is one of the hardest things for investors to do. What am I referring to? It's this: Breaking away from the tendency, in making investment decisions, to be highly influenced by how things have been going lately, and then assuming such observations suggest that the same general type of results will carry forward for at least the next several years, if not indefinitely.

While it may often be true that investments that have been doing well lately will continue to do well over the relatively shorter term, investors, in my opinion, should be much more cautious when ETFs/ stock funds appear to be showing signs of moderate to gross overvaluation. Those happenstances may not occur that often: they most likely will occur mainly late in extended bull markets.

Investors mindfully, but perhaps just sub-consciously, have much greater tendency to invest more in stocks during a long bull market, and with greater confidence, than when stocks aren't in one, and instead are either a) just chugging along moderately well but not some downside, b) essentially going nowhere over a considerable period, or c) are in, or near, a bear market.

For many, it seems hard to not to invest more during a prolonged bull market, and also not to invest in the prior best performing types of funds under what appear to be highly favorable conditions. People seem naturally inclined to extrapolate past to future. They tend to assume that what has been working well will continue to do so, which in the case of a bull market, is typically stocks in general. Additionally, they also tend to believe those specific categories of stocks which have been performing particularly well, and the best performing market sectors, will continue along the same path.

A Re-think Is Often Necessary

Under such circumstances, investors, rather than investing as they might have before the overvaluation began, need to think even more than otherwise, about what their returns might be as far as three years ahead, as opposed to, say, merely over the next six months, or even the next year or more.

Why? Here are some data showing what might otherwise happen:

About a year and a half ago (July 2014), stocks from around the developed world were on a tear. Prior one year returns were at least 20% pretty much no matter where one looked, and even more caution-inducing from my point of view, 5-year annualized returns were generally in the high teens, such as the S&P 500 index, up 18.8%. Virtually all stock fund categories were overvalued, as repeatedly emphasized over many months before that date in articles I authored on my website and elsewhere, including on Seeking Alpha.

Which types of stock funds were looking the strongest, and therefore, to the unwary, deemed most likely to continue their sizzling performance? Some sector fund returns were showing near 30% one-year returns or better, including health care, natural resources, and technology. Over the prior 5 years, small- and mid-caps, as well as health care and real estate sector funds were approximately averaging at least 20% annualized returns. So, it is not surprising that back then, aside from investing heavily in the broad market and international stocks, investors had also gravitated toward relatively large positions in small caps, mid caps, and the above sectors through funds and ETFs.

By one year later, that is, by July 2015, the returns on these investments presented a mixed picture. While the S&P 500, mid-caps and small-caps were still holding on to moderate one year gains in the 6 to 7% range, international stocks had generally tanked into moderately negative territory. Only health care sector funds continued to sizzle; while technology and real estate funds were still positive, they slowed considerably from their prior performances.

Now here we are a little more than another 6 months later. So where do these year and a half ago choices stand today? Most of the above gains have been wiped out, or nearly so, although small health care gains still remain intact.

The following table shows prices for some representative Vanguard stock ETFs from the start of the period compared with now (all data in this article thru Jan. 25). The percentage change in price gives one a close approximation as to how each ETF has performed over the period. Such ETF performance can be taken as a close proxy for other identical category funds, both unmanaged and managed:

ETF (Symbol)

6-30-14
Price

1-25-16
Price

Percent
Change
Over 1.5+ Years
(not annualized)

S&P 500 ETF (NYSEARCA:VOO)

179.46

172.07

-4%

Mid-Cap ETF (NYSEARCA:VO)

118.66

107.64

-9

Small-Cap ETF (NYSEARCA:VB)

117.12

98.34

-16

Total International Stock ETF (NASDAQ:VXUS)

54.15

40.96

-24

Health Care ETF (NYSEARCA:VHT)

111.58

122.31

+10

Materials ETF (NYSEARCA:VAW) (Natural Resources)

111.77

80.97

-28

Information Technology ETF (NYSEARCA:VGT)

96.75

98.82

+2

REIT ETF (NYSEARCA:VNQ)

74.87

75.93

+1

Click to enlarge

Note: An ETF's total return, including dividends and capital gains if any, is not reflected when just looking at the above prices alone. So, for example, if a given ETF pays a 2% yearly dividend, you will not see how that dividend affected the fund's year and a half return. To get a better estimate of actual performance, you would need to add the approximately 3% in dividends for the 1 1/2 year period to the percent change shown above. This also applies to all the percent change figures below.

Implications for Stock/Bond/Cash Allocations

Are there any other types of investments investors might have considered investing more in back in July 2014? Unfortunately, most other categories of stock ETFs/funds have not performed any better, and some have done even worse.

On the other hand, in some cases, where returns for many the above types of stock funds have been negative, at least for the period under consideration, investors would have been better off by just being in cash or money market funds. While such funds hardly returned much more than zero, at least they did not show negative returns.

How about bond funds? The following chart shows prices for some representative ETFs and funds from Vanguard then and now.

ETF/Fund (Symbol)

6-30-14 Price

1-25-16 Price

Percent
Change
Over 1.5+ Years
(not annualized)

Total Bond Market ETF (NYSEARCA:BND)

82.15

81.31

-1%

Total Intl Bd Idx (MUTF:VTIBX)

10.25

10.62

+4

Interm-Term Tax-Exempt (MUTF:VWITX)

14.14

14.37

+2

Click to enlarge

Note: Returns from tax-exempt bond funds should be regarded as higher than they appear because, unlike with taxable bonds, one typically gets the full return rather than the after-tax lowered return that will result from ordinary bonds held in a taxable account.

But Short-Term Returns Often Fail to Show the Whole Picture

Of course, the above data presents only a snapshot taken at the current point in time. Therefore, one cannot say conclusively that investors will continue to have been better off in non-stock investments because, if held further, the stock investments could well rebound and eventually outpace holding the non-stock investments.

Obviously, though, there is no guarantee that stock prices will quickly return to their winning ways. And because it is a fact that many investors do wind up switching out of losing positions and thus missing out on eventual recoveries, it may therefore turn out that many investors would have been better off by not having invested as much as they might have in mid-2014's overvalued stock funds, and instead, by having reallocated some of these investments to cash or bonds.

Thus, while we still don't know how well stocks will do in the next few years, it is highly possible that there would have been some better options looking forward from mid-2014 than the well-performing, but overvalued, funds/ETFs mentioned above.

Instead of investing based on current data which often just suggests, at best, a possible relatively short-term investment direction, it is often better to invest with at least a three year horizon which looks beyond the "here and now" and tries to anticipate where things are more likely to go if and when there is a change in underlying economic data and/or investor sentiment.

And over such a lengthier span, it makes sense to consider the downside of sticking with highly "overvalued" fund categories, and the potential upside of any possibly less overvalued categories that may not have performed as well but are still likely to do considerably better in the future. Another possibility is just to become more defensive, increasing one's allocation to cash, and possibly, bonds.

A Flashback to the Past

Is there a recent comparable period of time in which investors turned out to have likely mistakenly gravitated toward high-flying stocks? The last time this happened was in the fall of 2007 when, as above, virtually all stock fund categories had become overvalued.

The average US stock fund had returned 17.6% over the prior year and 16.1% over the prior 5 years annualized. International stock funds had done even better, showing 26.3% and 22.6% gains over the same periods. Among the standout categories were mid and small caps, technology, communication, utilities, natural resources, and emerging markets.

On the other hand, at that time, bond funds weren't doing terribly, but not particularly well over the prior 5 years with the benchmark (NYSEARCA:AGG) returning 4.1% annualized.

But things turned around sharply over the following three years. Most of the above mentioned stock fund/ETF categories showed deeply negative 3-year returns by the fall of 2010. The AGG bond benchmark, on the other hand, returned better than 21%, or 7% annualized. The following table shows how some of the high-flying stock performers in the fall of 2007 fared over the following three years:

ETF (Symbol)

9-28-07
Price

9-30-10
Price

Percent
Change
Over 3 Years
(not annualized)

S&P 500 ETF

140.61

105.06

-25%

Mid-Cap ETF

79.64

66.30

-17

Small-Cap ETF

72.63

63.51

-13

Total International Stock ETF

20.67

14.95

-28

Information Technology ETF

60.68

55.59

-8

Telecommun Serv ETF (NYSEARCA:VOX)

83.09

62.72

-25

Utilities ETF (NYSEARCA:VPU)

83.02

66.36

-20

Materials ETF (Natural Resources)

88.05

70.92

-19

FTSE Emerging Markets ETF (NYSEARCA:VWO)

103.80

45.35

-56

Click to enlarge

Now, here's how two Vanguard bond funds and its main money market fund did over the same 3 year period:

ETF/Fund (Symbol)

9-28-07
Price

9-30-10
Price

Percent
Change
Over 3 Years
(not annualized)

Total Bond Market ETF

75.44

82.56

+9%

Interm-Term Tax-Exempt

13.19

13.89

+5

Prime Money Market Fund (MUTF:VMMXX)

1.00

1.00

+5

Click to enlarge

Note: Return for the money market fund was 1.5% annualized, or approximately 5% non-annualized over the period.

Final Thoughts

While history unlikely ever exactly repeats itself, and 2007 through 2010 was undoubtedly different than 2014 through 2016 and beyond will be, investors should be on guard against certain similarities. Evidence suggests that once stocks get "ahead of themselves" for too long, returns tend to be subdued, if not outright negative, for a number of years going forward.

Research I have conducted suggests that making "contrary-to-the-prevailing-sentiment" decisions based on extreme overvalued (or, for that matter, undervalued) conditions may appear wrong-headed and wrong-footed over the short term. However, over periods of at least three years, these decisions likely will come out ahead of sticking with what the majority of investors opt for as their current favorite choices which are often based heavily on current conditions, relatively devoid of overvaluation considerations.

Disclosure: I am/we are long VOO, VO, VB, VNQ, VWO, BND, VTIBX, VWITX, AND VMMXX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.