What Should You Do With Expensive Stocks?
If you want to buy a house, a car, or even a vacation, you’ll look for the best price. No one wants to pay too much when making an important investment. So how should you deal with expensive stocks in your investment account or on your watch list?
Investors are Challenged by Expensive Stocks
The U.S. stock market is full of good news right now. Just last week, the major U.S. averages scored a perfect “trifecta” of new highs. (This “trifecta” included the Dow, the S&P 500 and the Nasdaq all hitting new highs on the same day).
Investors are optimistic. Returns are positive. And stocks are expensive.
But is that really a good thing?
Sure, if you’ve been holding a portfolio of these expensive stocks for the last several quarters you’ve accumulated some great profits.
But what do you do with those positions now?
And what about new capital you’d like to invest? These are unique challenges that make managing your family’s investments a difficult task right ow.
Measuring Expensive Stocks Valuation
So what does it really mean to say stocks are expensive?
Traditionally, investors have looked at how much a company earns compared to what you pay to own that company. A simple way of measuring this is through a Price / Earnings ratio (or PE ratio). The higher a stock’s PE ratio, the more expensive that stock is.
For example, let’s say you’re looking at the stock of a company that earns $5 million a year. There are five million shares of this stock currently available for investors to own. So the company has earnings per share of $1.00. ($1.00 per share times 5 million shares = $5 million in annual profit)
Now if this stock trades at $15 per share, the stock would have a PE of 15. In other words, investors pay 15 times the company’s earnings to own that stock.
So as a general rule, expensive stocks have high PEs and cheap stocks have low PEs.
You can’t simply look at the price of a share and say “this $100 stock is expensive and this $10 stock is cheap.” You have to look at the price of a stock in comparison with the actual profits (and expected profits) of the company.
Of course there are other metrics investors use to measure the valuation of stocks. And there are good reasons why some stocks are more expensive and some have lower values. It takes experience to understand why stocks are expensive or cheap and to pick out good opportunities.
Current Valuation Indicates Risk
Today’s market features an abundance of expensive stocks. In fact, this is one of the most expensive periods for stocks in recent history.
This week, the Wall Street Journal ran a story discussing the “warning sign” of today’s expensive market. The article used a variation of the PE calculation (adjusted for cyclicality and inflation) to show just how expensive stocks are.
Part of the reason stocks are so expensive is because investors have fewer opportunities to invest for income. The Fed’s experiment with zero percent interest rates has made it very difficult for conservative investors. Investment grade bonds now yield next to nothing. So investors who need yield have to find new places to invest.
This has given investors incentive to put money in more risky areas of the market. (Dividend stocks are historically more risky than bonds. But even conservative investors are buying these stocks because its the only way to generate yield.)
Today’s mixed up market has caused many professional investors to throw out their play books for what should work in a more “normal” environment.
“Investors are buying bonds for capital appreciation and stocks for income… The world has turned upside down.” ~James Abate, CIO at Centre Asset Management (as quoted by Jim Grant)
But although expensive stocks have pushed this market higher, that doesn’t necessarily mean you should sell everything and go to cash.
Valuation Is Not a Timing Mechanism
So what you should you do with this information? Should you go ahead and sell all of your stocks now? Better yet, should you short stocks, betting on an all-out market crash?
Not so fast…
Legendary economist John Maynard Keynes famously said, “The market can stay irrational for longer than you can stay solvent.” In other words, just because stocks are expensive (or cheap) doesn’t mean they will turn around immediately. In fact, the market could continue to be expensive for some time to come… Or it could get even more expensive before turning around.
That’s why its dangerous to take just one data point and change your entire investment approach because of it.
On that note, I got a lot of feedback from an article I wrote last week about how safe dividend stocks may be in trouble.
Idelle wrote: “Zach, are you saying that the dividend stocks I purchased to Piggyback the Canada Pension Plan are in trouble?”
(The “Canada Pension Plan” comment references my dividend stock newsletter Lifetime Income Report. We’ve been paying particular attention to the most attractive dividend stocks that are owned by the Canadian version of our U.S. Social Security.)
It is important to note that just because stocks are trading at high valuations, doesn’t mean you need to go out and sell right away.
Instead of using valuations as a timing mechanism, consider this a sliding scale of opportunity and risk.
When stocks are cheap, there is typically less risk and more opportunity. This is because stocks are already trading at low prices, and the pendulum could swing the other direction. Conversely, when the broad market has high valuations, there is more risk and less room for further expansion.
Two Ways to Invest in Expensive Stocks
There are two strategies I like to use when the market is full of expensive stocks. These strategies can help you continue to capture gains if shares move higher. And they can keep you from the frustration of buying shares at peak prices (only to watch your stocks pull back).
The first strategy is to use trailing stops. This is good for shares of stock that you already own.
A “stop” order simply means that if shares pull back to a certain level, you will sell your position and exit the trade. A “trailing stop” takes that one step further and automatically adjusts your exit point as your shares continue to move higher.
My second strategy for investing in a market of expensive stocks is to sell put contracts on stocks that I would like to own. This is a good way of generating income from cash that you have not yet put to work.
When you sell a put contract, you’re entering an agreement to buy shares of stock at a discount. Of course, you’re getting paid to enter that agreement. So not only do you have some room for your stock to pull back, you also have some income to offset any additional decline in the stock.
If you use this strategy with extra cash you have in your account, you’re guaranteed to not buy shares at a peak price. Meanwhile, you can still get paid income as the market continues to advance.
Bottom line, stocks are expensive right now. That means you should exercise caution with your investments. But rather than selling everything and “sitting this one out,” It makes more sense to manage your positions carefully and use alternative strategies with cash you have on the sidelines.