Thursday, December 29, 2016

Is it a good time to invest new money? Or is it a time to be cautious?

First you need to ask yourself the following questions: What is my investment time horizon for any new lump sum of money? Do I need this money in the next few years or can I leave the money invested for at least 5-7 years?

If the answer is you need this money in the next 3-5 years, then you are better off putting the new money into fixed income instruments such as Savings account, a CD, Treasury or Corporate/Municipal bond earning 1% - 3% rather than investing in risky stocks.

Why am I saying this? Well, just look at the 20 year F.A.S.T Graphs S&P 500 stock market chart below:

Historical S&P 500 Price Chart  - Copyright 2017, F.A.S.T Graphs - All Rights Reserved

The black line is the S&P 500 Index price movement over the past 20 years. The green area represents the cumulative earnings of the companies that make up the broader S&P market index and the grey bars represent recession periods.

In the last 20 years, we have had two recessions, one starting in the year 2000 and the second starting in 2007. Prior to each recession, the market got into a bubble territory which ended in a 40+% decline or market crash. A bubble is formed anytime the price of a stock or broader market Index deviates upward and separates from the underlying earnings growth by a wide margin.

Regardless of the short-term price fluctuations, long-term the price (black line) always tracks the underlying earnings. Think of earnings as gravity that pulls the price towards itself. The orange line in the above chart represents and tracks fair value which is a PE multiple of 15.

Anytime the black line (price) is above the orange line (fair value), the market is considered to be overvalued whereas price below orange line represents under value.

So, given the current market price is at a nearly 20 times the underlying earnings while earnings have been mostly flat for the past two years, and the gap or bubble between the earnings and the price has only gotten bigger since the recent elections, we are definitely due a major correction if not a recession. A correction would be a decline of 10% or more in stock price across the entire market.

Knowing this, would I commit a large lump-sum of money at this point in the market; especially, if I need this money in a few years?

The answer should be a resounding 'No'.

I would not want to commit a large sum of my hard-earned money in the broader market when the market is at all time high and clearly in a bubble territory, a bubble that is formed purely based on unproven growth expectations and on the back of Trump rally.

Chances are there will be a correction soon into the new year, maybe as soon as January. It would likely be caused by a combination of tax selling and realization that election promises such as tax structure changes and financial regulation reforms will take time to implement and may even require compromises on part of the new administration to get these changes approved.

Bottom-line, election promises are merely promises till they are actually implemented. A market trading purely on such promises is likely to be disappointed in the short-term.

The worst thing an investor can do is invest a lump-sum amount at the peak of a bubble and then watch it significantly decrease in value in a matter of weeks and months and then have to wait for years to recover.

Timing the market for a correction is hard, even for professional investors. A better strategy would be to dollar-cost-average into current market using low cost Index Funds. I use this strategy as an additional safety even when buying individual stocks at fair or below fair value in my non-retirement accounts.

The dollar-cost-strategy helps protect my investments in case of a sharp decline (as my cost is gradually spread over multiple time periods and price points, and one or two sharp price declines would have only limited impact) while allowing me to still continue to invest in an overvalued market and reap the benefits over long-term by staying in the market.

How are you investing in the current market? 

Disclaimer: Author of this article is not a licensed/registered financial or investment advisor and does not provide investment advice. This article is for informational purpose only. Full disclaimer can be read here: Full Disclaimer

2 comments:

  1. The market will no doubt drop at some point in the future. Timing the market is always a hard thing to do, that's why it's important to dollar cost average your stocks. I try to do this as much as possible.

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  2. We should see a dip in January due to tax selling. I think it would cause a bigger dip than in the previous years due to hopes for much lower taxes. I would be selling/trimming a few overvalued stocks, hopefully before the actual dip.

    A bigger correction may come in a bit later as market starts to realize that not all policy change expectations would come true. There is also the China trade risk.

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