In Overvalued Market, Clients Need Reality Check

Advisors grappling with a potentially topped-out market may well need to discourage clients from going “all in” on stocks right now.

But is a candid discussion on “behavioral investing” a good place to start?

Some investment experts think so. They say that the market is approaching “irrational exuberance” levels (the infamous term then-Fed Chairman Alan Greenspan used to describe investor sentiment in 1996.)

The Federal Reserve certainly believes the risk that stocks are topping out is a strong one. In its March meeting minutes’ release, the Fed stated the following:

"Broad U.S. equity price indexes increased over the intermeeting period, and some measures of valuations, such as price-to-earnings ratios, rose further above historical norms. ... Some participants viewed equity prices as quite high relative to standard valuation measures."

The Fed is hardly alone in issuing cautionary statements these days. A recent survey from Bank of America Merrill Lynch stated that 34 percent say stocks are "overvalued” – the highest number since the survey was introduced in 2000. Additionally, approximately 80 percent of the 165 fund managers surveyed said the U.S. stock market is the most overvalued market across the globe.

Getting Emotional

What does this all have to do with behavioral investing? Plenty, investment experts say. With investment sentiment at record highs, and the VIX volatility benchmark at record lows, tamping down emotionally-charged market expectations could well be job No. 1 for financial advisors.

“By definition, behavioral investing theorizes that, due to various emotional and mental
biases and errors, humans do at times act irrationally in the markets,” said Samuel Smith, an analyst with Seeking Alpha, a prominent investment and financial media platform.

“Having an understanding of how emotion and the influence of the market and media changes investor behavior, combined with the patience and discipline to apply that knowledge, is critical to outperforming the market in the long run,” he added. “When prices rise during a market bubble, investors must look extra carefully at the underlying fundamentals to determine if stocks or funds are truly worthy the investment, or if the artificially inflated economy and/or the stock market are making sub-par opportunities look enticing.”

For evidence of the latter outlook, Smith cited the technology bubble of the 1990s and the housing bubble of 2006-07.

“It’s often times best to diversify funds away from being entirely concentrated in the stock market and placing them in alternative investment assets, or even leaving some in cash, in order to buy back in to the market once the bubble bursts and sound investment opportunities return to reasonable, or even cheap, prices,” he said.

Behavioral tendencies also give investors a false confidence in their own stock-picking abilities, a scenario that rarely works out for market participants.

“Our behavioral biases often times impact our decision-making process around money and investing,” said Stephen Rischall, a founding partner at 1080 Financial Group in Sherman Oaks, Calif. “Simultaneously, current overconfidence bias suggests that investors may overestimate their knowledge when it comes to financial decision making, while in reality many investors are at an informational disadvantage.”

'People Tend to be More Excited'

In good times, investors tend to be overoptimistic, often to their own detriment, he explained.

“Everyone has heard the adage of ‘buy-low and sell-high,’ but in practice it's times like these, when the markets are roaring, that people tend to be more excited about investing money,” he noted. “This causes investors to do the exact opposite of buy-low, and you don’t hear that investors are excited to invest more money when the markets are declining.”

Others say that stock market volatility is inherently the product of human behavior, even if investors don’t realize that.

“Often that behavior is rational in the short-to-medium timeframe based on the underlying value of the asset,” explained Sean Linehan, vice president of product at Flexport, a San Francisco-based technology and data company.

In the short run, it's always possible to profit from people's emotional, very human bias, as it “gets in the way of their rational judgment,” said Linehan, who has studied the history of financial markets extensively.

He points to a recent, high-profile example involving one of America’s most prominent corporate brands as an example.

“One great strategy is buying stock in a company after a negative public relations storm that is unrelated to their underlying business success,” Linehan said. “Take United Airlines. After that video, their stock fell from $73 to $40. The severity in the drop was extremely irrational and since then it has rebounded to an all-time high.”

With the stock market highly overvalued, according to financial experts, it’s high time that advisors have the “behavioral” talk with clients.

They may not take it well, but that’s just going to prove your point – there’s no room for emotion when it comes to building a high return investment portfolio.

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at [email protected].

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