Is the market overpriced sources of passive income

Is the market overpriced?

Getting your sources of passive income requires a lot of knowledge. The question of whether the market is overpriced is a topic of endless discussion.  According to the Efficient Market Theory, which is the basis for mainstream investment advice, there market is always efficiently priced based on all available information.  So if you believe in this theory, it means there is never a point at which the market is on sale or overpriced.  It simply is where it’s supposed to be…..even if it crashes 5% tomorrow.

Is the market overpriced sources of passive incomeOf course we think that’s a bunch of nonsense since markets put things on sale all the time.  For example, buying a house in 2009 was probably one of the best times if you could afford it.  The recovery from the last market crash would have resulted in excellent capital appreciation of your home.  And it makes sense.  Whether the market prices them high or low, people have always used them for the same thing….a roof over your head.

That’s what real investing is all about.  If you view the market as not being so efficient, it means that assets can be on sale or overpriced in relationship to their intrinsic value.  The house didn’t change.  Just people’s perception about housing.

Price vs Value

Warren Buffet once stated that “Price is what you pay. Value is what you get.”  It’s a key distinction that value investors rely heavily on when targeting good deals.  In fact 2 of the most important rations investors look at are the P/E ratio which compares a company’s price to its earnings.  The other is ROA which is the return a company makes in relation to its assets.  Bond investors look at yields.  Landlords look at cap rates.  The bottom line is we want to understand how much money an asset can make us in relation to what we pay for it.

Many investors seem to forget that stocks aren’t just things that go up and down on a chart, or numbers that scroll by at the bottom of your TV screen.  Stocks shares represent ownership of real businesses. Businesses with real equity, real customers, real products, and a real ability to make or lose money.  If you find a business with a sustainable competitive advantage, and it’s making money hand over fist, the cheaper you can get it the better.  Even if you can’t tap into the earnings via a dividend, a growing company reinvests it’s earnings which drastically increase the value of your shares over time.

So back to the question…….is the market overpriced?  Is it expensive in relation to the earnings these companies report?  Well, here’s on way to measure it.

The Shiller P/E

Dr. Shiller, a Nobel Peace Prize Winner, and Professor of Economics at Yale developed a way of measuring whether the market was overpriced in relation to the performance of the underlying companies.  The Shiller P/E compares the price of the market as it relates to the 10 year average earnings of companies within the market.

What Dr. Shiller discovered was a way to tell whether the market was likely to correct or even crash.  Studies showed that any time the market had a P/E above 27, it was extremely likely that a sharp selloff was due shortly thereafter.  Historically speaking, stock market crashes like the one that cause the great depression, and the one that came at the end of the dot com bubble were periods which showed very high Schiller P/Es.

And it makes sense.  A business asset can only get so expensive before it just doesn’t make sense to buy.  The only reason you would buy something that would take a hundred years to pay you back is because you think it will just keeping going up in value.  However, that which goes up comes right back down.

Currently, as I’m writing this, the Shiller P/E is at 29.48.  The last time it was this high was right before the crash of Black Tuesday.  And while I never like to predict exactly when a market will crash, I wouldn’t be surprised if it happened sooner than later.

That’s why the rich aren’t at the mercy of the market.  They know how to invest during bull markets, sideways markets, and even bear markets.

If you ever need help developing your strategies during scary markets, just remember that we’re always here to help.

About The Author

herbertkoehler

I am a college drop out who found my passion as an investor. I love the many facets of finance, investing, and business. But even more than that, I love sharing what I learn with others.

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