The Market Is Moderately Overvalued
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands. -- Warren Buffet's letter to Berkshire Hathaway shareholders, 2000I continue to see the stock market as being moderately overvalued -- the higher we go from here, the line between speculation and investment seems likely to be increasingly blurred. In the past, I have suggested that in a 5% overvalued market, a conservative investor should not be more than 50% long -- and I still stand behind that. So, if I believe (as I currently do) that the market is slightly more than 5% overvalued, why have any investments in equities? The answer is obvious. At any given time (regardless of where the market is selling), individual stocks are overvalued and undervalued. This is particularly true today since there is so much uncertainty in fiscal (and monetary) policy, in political/economic outcomes and with regard to business and consumer reaction to policy. Don't take my word for the fair market value calculation. Again, I strongly encourage you to input your own earnings/economic/multiple expectations and create your own fair market value calculation. This allows investors and traders to pick sides on the issues and make their bets a bit more intelligently, particularly on the broader market. I hope you find this exercise to be helpful as a guideline.
This column originally appeared on Real Money Pro at 8:24 a.m. EDT on Oct. 21.