Investing is a fantastic way to compound wealth over time. Everybody knows that “a dollar invested today will be worth $100 in 50 years”. But what about when the stock market is inflated? Is investing STILL such a good idea when all the stocks are overpriced? What about when you KNOW that a stock market crash is coming, but you just don't know when. In this post, we will be breaking these questions down and tackling them one by one. I'll include some research, my own thoughts, and some of my personal experiences. Sit tight and get ready to learn how to invest in an inflated stock market environment.
What does “inflated” mean?
Before we jump into exactly how to invest in an inflated stock market environment, it's important to define what exactly “inflated” means. It's easy to say “Oh well in 2000 and 2006 the market was ‘inflated' and in 2002 and 2009 it wasn't” but that's not really a definition.
You could say “inflated just means when things are expensive,” but that's completely relative. If EVERYTHING is expensive, then nothing is. The same goes for if everything is cheap.
A good metric to define an inflated market might be “right before a stock market crash.” But then again, nobody can predict such a thing. So what is a good metric to define whether or not a stock market is inflated?
Personally, I think we can use the definition of when more money is circulating in the market which is intended to be day-traded than held for the long-run.
More Day Traders Than Investors
What does this mean? Well, I'm going to take cues from “The Psychology of Money” by Morgan Housel to try and explain it. Let's say you want to buy into the stock market and hold for the long-run. You care about buying stocks at a good price because you can weather short-term volatility and eventually when you sell, your buying price will play a big role in your total return. So you patiently wait for stocks to drop into your target range before buying.
Then there's me: the avid and obsessed day-trader. I (in this made-up scenario) don't CARE about the price of the stock because I'm not concerned with its actual value. I can buy a stock for $20 and sell it an hour later when it hits $21 OR I can buy the same stock for $100 and sell for $101. It makes no difference to me because I'm chasing immediate returns and will sell very quickly.
Perfectly Balanced, as All Things Should Be
Usually, there's this balance between day traders and long-term investors which keeps the markets in check. But every once in a while there will be a SURGE of day-traders which INFLATES the market.
How? Well, let's go back to that $20 stock. Let's say that I (the day-trader) buy the stock and hope to sell within the next week for a profit. If there's a balance of long-term investors and day-traders, the stock will probably stay relatively steady throughout the week and I'll sell for a tiny bit of profit. But if there's an overwhelming amount of day-traders and they detect upward momentum in a stock, they'll buy the crap out of it! The more they buy, the higher the stock price goes; the higher the stock price goes, the more momentum is created and the more the stock gets pumped up. NOW the stock is “inflated” because it's not high due to its intrinsic value but rather because of the hype.
This is what happened in 2000 and 2007. In 2000, EVERYBODY was chasing a quick profit in the stock market because everybody else was: “buy the TECH STOCKS! They're going up! You'll make a fortune!” And alas, things came crashing down when people started cashing their stocks in. In 2008, EVERYBODY was taking out mortgages and buying homes: “the housing market is HOT! Everybody needs housing! The housing market can't crash, this is guaranteed money.” And the rest is history.
There's a saying on Wall Street that goes something like “when your taxi driver starts giving you stock tips, it's time to sell everything.” They know that when there are more people in the market chasing a quick buck rather than investing for the long-term, that's when the market is inflated.
Current Market Outlook
Quick disclaimer: I'm not a financial professional. Though I do currently work a job in finance, I am in no way licensed or certified to hand out financial advice. These are just my OWN THOUGHTS on the market.
That being said, not having any responsibility for your finances allows me to write freely without having to come up with analytics, financials, and extensive proof.
My opinion is that the market is indeed approaching “inflated” status. Here are the main pillars of my thesis:
- Unemployment is reaching unprecedented levels and we're in the middle of a pandemic yet the stock market is no more than 3% away from its ALL-TIME HIGH.
- Unemployed people and just people, in general, are seeking quick, easy ways to make money and trading stocks can be viewed as “easy”.
- Apps like Robinhood are making it more and more accessible for people to trade stocks.
- People are bored and at home and have TIME to trade stocks now.
“Sorry, the market's just irrational”
About a week ago I was sitting at my desk at work when the VP came over and asked for a task. “Yo Jeff, can you look at this company's financials and do some digging to find out why they're so expensive (why their stock is so high) right now? Oh also there has to be a reason; don't just come to me and say ‘the market's just irrational.'”
I dove into the task checking sites like BamSEC and Capital IQ for the company's financials. On top of that, I also read through articles on The Motley Fool and other financial news sites trying to figure out what the public's opinion of the stock was. After an hour or so, I came to him with all my research and said “sorry, the market's just irrational.”
The stock was priced high before COVID, then after a severe dip in March 2020, it rose and rose and kept on rising until it was at a ridiculously high price. The VP checked my research and concluded that it indeed was an expensive stock for no other reason than market irregularities.
The Inevitable Crash
Benjamin Graham said something like “every day that the stock market rises is a day closer to its crash.” That statement is truer still in an inflated stock market environment.
The crash is going to come, guaranteed. If there weren't crashes, the stock market wouldn't be “risky”. And if it wasn't risky, then everyone would make money. And if everyone makes money, then nobody does.
BUT, just because a crash is going to happen doesn't mean we know WHEN. The S&P 500 could come tumbling down 50% tomorrow or it could rise for another 8 years before the crash. Knowing that something will happen and knowing WHEN something will happen are two very different things.
Investing in an Inflated Stock Market Environment
That brings us to the crucial question: how does one invest in an inflated stock market environment. My answer: the same as you normally do (with a little extra liquidity.)
“Wait but Jeff, you just said that the stock market was going to crash!!”
Yes, I did, but again nobody knows when that will be. Only that it WILL one day happen. It's like going through life knowing you're going to die eventually. Yes, it WILL happen… to everyone. That's Guaranteed. But if you forbid yourself from enjoying life because of inevitable death, you'll miss out on a LOT of amazing things.
If you prevent yourself from entering the market because the market is inflated, you risk missing out on A LOT of potential gains. Plus, there's never the perfect time to enter a market. If you stop yourself from entering an inflated market, you might stop yourself from entering a DEflated market:
“I'm not gonna invest now… the market is WAY TOO HIGH.” *stock market proceeds to go down a lot* “OMG I WAS RIGHT…… there's no WAY I'm investing NOW, the market will keep going down…” *stock market recovers* “No…. the market is too expensive I'm not entering now…”
Bears vs Bulls
Historically speaking, bull markets last WAY longer than bear markets. What does that mean in layman's terms? It just means that usually, stocks are going up. And when they DO go down, it doesn't last for a long time.
For investors, this is good news! It means that even if the stock market crashes, it will probably not stay that way for long. And if you invest through it, you could make a lot of money.
This is where that liquidity part from earlier comes in. If you believe that the market is inflated, I recommend holding some cash on hand (maybe around 20%). This way, if the market crashes, you can take advantage of discount prices. If it continues to go up, you still have 80% of your portfolio tracking it.
Pray for a Crash if You're Young
If you're 65 and relying on your investments as a source of income, you probably don't want a crash. BUT, if you're young, you should relish the opportunity to experience a stock market crash.
Why? Because a crash will not only bring you discount stock prices, but ALSO wipe out a huge amount of the competition. A lot of irresponsible people are out there investing with borrowed money and leveraging themselves up to the neck. They may make a lot of money when markets are doing well. But as soon as a crash hits, they'll lose everything.
Not to say that this is good (although it might teach them a well-needed lesson), but it DOES present YOU, the responsible investor, with an opportunity. The less competition there is, the more opportunity there is. And the more opportunity there is, the more money can be made.
If you're young and have time to bounce back, you should love stock market crashes because they'll give you the opportunity to get ahead!
Get Out There and Invest!
That's it. Those are my thoughts on how to invest in an inflated stock market environment. To quickly recap:
- A market is inflated when there is more day-trader money circulating than long-term investing money (imo)
- We are currently approaching inflated market status
- Just because the market will crash doesn't mean we know when
- In an inflated market, just invest the way you normally would but hold more liquidity
- If you're young, you should look FORWARD to a stock market crash
So what are you waiting for? Get out there, start investing, and start building your wealth!
What are your thoughts on the market today? Should you treat inflated stock markets differently? Will the market crash soon? I want to hear your thoughts in the comments!
Thanks for reading through How to Invest in an Inflated Stock Market and thank you for following along! If you're a Canadian Student, check out the Ultimate Canadian Student's Guide to Personal Finance! To learn more about me, head over to this link here. If you want to get exclusive updates and tips, drop your email in the “get updates” box (might have to scroll up a bit.) Let me know your thoughts and suggestions in the comments!
Jeff is a current Harvard student and author of the blog Financial Pupil who is passionate about learning, living, and sharing all things personal finance-related. He has experience working in the financial industry and enjoys the pursuit of financial freedom. Outside of blogging, he loves to cook, read, and golf in his spare time.