The way to make a profit trading stocks is to buy or sell just as the market starts to make a move and get out of the trade when the market stabilizes. When the market it too high it is typically time to sell and when it is too low that is when stock traders typically want to buy. So, when trading an overpriced market, traders ought to be ready to sell. But, what if stock prices go up and stay there? A recent article in the New York Times speculates about the Mystery of Lofty Stock Market Elevations. The writer, Robert Shiller, says that
The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop - is hovering at a worrisome level.
The author goes on to note that the last times the CAPE ratios (the P/E ratio using a ten year average of earnings) were this high were before the market crashes in 1929, 1999 and 2007! Our thoughts on trading an overpriced market are three.
- The relative overpricing of stocks is there for a reason and may last for years
- You can still make a profit on the upside
- When the underlying reasons change you need to be ready to short everything in sight
Money Follows the Best Return on Investment
After the market crash of 2008 somewhere around $7 Trillion simply disappeared. The risk of another Great Depression was real. The actions of the US Federal Reserve in pumping equity into the economy, dropping interest rates to near zero and supporting credit markets was successful and the worst recession in three quarters of a century is slowly receding. Along the way interest rates on bank deposits and bonds have been very low. Investors have looked to the real estate market for bargains and accepted overpriced stocks as the best of an otherwise bad deal. Thus, so long as the other options are less profitable investors will keep plowing money into an overpriced market. And traders will be trading an overpriced market until interest rates rise, which may be in a year or so, according to the minutes of the Federal Reserve meetings. Although stocks are currently overpriced when compared to earnings by historic standards they are no overpriced according to market conditions today. But, what happens when interest rates go back up?
When to Get Out of an Overpriced Market
When everyone wants to buy stocks and gurus say that this time it is different is when to get out when you are trading an overpriced market. Forbes published a tongue-in-cheek top ten signs of the coming stock market crash. We include a few here:
Everyone stops talking about a crash.
All the people who used to talk about a crash have been fired.
Your brother-in-law quits his job selling jacuzzis to day-trade stocks full time.
Top money managers on Wall Street tell polls that they have never been more bullish.
Taxi drivers give you their stock tips on the way to the airport - and you write them down.
Reading Market Sentiment
When you are trading an overprice market there is still day-to-day movement and a profit to be made. When an overpriced market collapses there are fortunes to be made! Technical analysis is the key to reading market sentiment at the point when an overpriced market becomes volatile and is ready to head downhill. If you have made money as the market has inflated take a little profit and take it now. Then watch carefully for the signals that predict the bursting of the current stock bubble and or short everything in sight. And, remember that if you do not understand the market or what you are doing it is perfectly acceptable to get out now!
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