Investor Greed Could Hurt Your Retirement
U.S. stocks are hitting new highs, and that’s leading to a significant amount of investor greed.
According to CNN’s Fear & Greed Index, investors are now operating from an “extreme greed” perspective.
The sentiment represents a dramatic shift from the weeks and months leading up to the U.S. presidential election. During the summer months, uncertainty caused many investors to take capital out of the market. They didn’t want to be left holding too much risk with such a key event in play.
But now that the election is over and the market is logging new highs, that capital on the sidelines has become more of a liability than an asset. Fear of missing out (aka FOMO) is driving institutional and retail investors’ decisions.
The challenge is especially tough for institutional investors. These investors could be penalized (or fired) for not keeping up with the market. As the market moves to new highs, institutional investors must take more risk just to catch up with market returns.
For now, this greed is helping retirees grow their investments.
But higher prices and excessive greed may also be setting the stage for much more risk in 2017.
Investor Greed and Market Valuations
A rising stock market can be very helpful for the U.S. economy. But it’s important to watch the relationship between stock prices and the actual profits that companies are generating.
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We recently talked about how much to pay for your stocks. One of the best ways to determine a “fair” price for investing in a stock is to look at the price / earnings ratio (or PE Ratio).
If a stock’s PE is 15, that means you’re paying 15 times a company’s annual earnings to own that stock. On the other hand, a PE of 30 means that it costs twice as much (for every dollar the company earns) to purchase shares. Investors should look at the value of what they are buying instead of just the market price for each share.
U.S. stock values have been growing steadily for years. Unfortunately, corporate earnings have not been growing nearly as fast. So it now looks like investor greed is largely what is driving the market higher.
The result is that investors are now paying much more (per dollar of corporate earnings) than they have been in the past. Below is a chart showing the PE (or price per dollar of earnings) that it costs to invest in the benchmark S&P 500 Index. (Source: Multpl.com)
Investors are now paying $25.84 for every dollar of profit that U.S. companies generate.
In the last century, there have only been two other times when investors paid more for stocks. The first occurrence was leading up to the “dot-com” crash in 2000 and 2001. And the second occurrence was just before the financial crisis of 2007, 2008.
For investors who care about protecting their capital, this should be an important warning sign.
Valuation Doesn’t Matter… Until it Does!
John Maynard Keynes famously said “The market can stay irrational longer than you can stay solvent.”
Just because the market is trading at a premium valuation doesn’t mean that we’re in for a selloff immediately. In fact, shares could continue to climb for weeks, months, or even years.
Valuation — or noting that the market is trading at an extreme price point relative to earnings — is not a good timing tool. So today, I’m not recommending that you liquidate your retirement account and go to cash.
But what I DO recommend is that you start thinking about a game plan for what to do when the market rally ends.
Considering the high value investor greed has placed on stocks, the next decline could be very intense. Imagine what would happen if company profits were static and the market’s PE went back to 10 (where it was in the early 1980’s). That could wipe out more than half of today’s stock market wealth!
Of course, that is an extreme (and unlikely) example. But extreme movements do happen from time to time.
One move you might want to consider is taking some of your profits off the table over the next several months. You may want to consider selling profitable positions after the New Year begins to take advantage of potentially lower income tax rates.
Another option would be to move some of your retirement into more conservative income-generating strategies such as selling put contracts or setting up credit option spreads. These strategies can help limit your risk in case the market trades lower.
You worked hard to build your retirement account. It’s going to be important to protect that account in the weeks and months ahead.
Here’s to growing your income!