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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Should I Invest In This 'Overvalued' Stock Market?

Firstly, equity is an important asset class to create wealth. If you are not into equity, you must do so ASAP.

Secondly, equity investment requires high levels of expertise and experience. If you are not a stock market expert, you MUST take recourse to the mutual funds (which are managed by 'qualified and professional' fund managers).

Last but not the least, equity investment requires high levels of discipline and patience. If you don't have such qualities, you MUST develop and nurture them.

With this preamble, let's get to the core of this blog post... should you invest in the stock markets at the current levels, when the valuations are definitely rich and expensive?

Over the last one year or so, the growth of the Indian Economy has suffered a setback and is trending downwards.

Over the last one year or so, the growth of the Stock Markets is enjoying a boom period and is trending upwards.

This is extremely strange (and dangerous too):

Why is it strange?
After all, stocks are nothing but ownership of businesses. Hence, stock prices should ideally reflect their economic performance. So, the two going in exactly the opposite direction, is definitely strange.

But that's the very nature of Stock Markets. They are highly unpredictable. Actually, if they were predictable, then there would be no difference between stocks and fixed deposits.

Important to Note: Having said that, such irrational behaviour of the Stock Markets is normally a short-term feature. In the long run, say over 3-5 years, they both converge. Bad stocks will give bad returns. Good stocks will give good returns. As simple as that!

And, why is it dangerous?
Given the current divergent behaviour, the earnings have dropped (i.e. Earning Per Share or EPS is down), but the share prices have increased. Consequently, the Price-to-Earning (PE) Ratio has gone up.

Typically, over the last few decades of the Indian Stock Markets, the lowest PE ratio has been around 10-12. The highest PE ratio has been around 28-30. And, the average around 17-18.

Based on this historical background, the current PE of around 23-25 is definitely expensive. [Read: PEG Ratio Demystified]

If, as per expectations, the Indian Economy recovers, then the businesses will deliver higher profits. Hence, we will have higher EPS. This will bring down the market valuations to the average — and comfortable — levels.

However, if the economic growth continues to remain muted, sooner or later the investors will lose patience. And the markets will CRASH. Hence, the present situation is 'dangerous'.

So, should one stop investing (and wait for the valuations to come down)?

Well, the answer is NO.

Should you pull the trigger on your Equity Investments?

a) As mentioned earlier, the market behaviour is irrational in the short run, but corrects itself over long term.
b) Even in this somewhat gloomy economic scenario, it is possible to find 'good businesses' at 'good prices'.

Therefore, the most logical thing to do is... TO TREAD AND TRADE WITH CAUTION.

When the weather is bright and sunny, and the roads are wide and well-maintained, you can drive freely.

But, when the weather conditions are adverse, the visibility is poor and the road slippery, you have to drive with caution.

Unless the situation is terribly bad, you don't stop. You have to keep driving to your destination.

Likewise, the present market scenario may be a bit worrisome, but is definitely not terrifying.

So you don't stop investing. You have your goals to achieve. 

You merely become more careful:

First, if your equity investment is already high, you MUST do some profit booking and bring down your market exposure.

Second, in these difficult times, stock picking has become all the more difficult. At low valuations, almost anything and everything goes up. But, in the given conditions, you have to be extremely choosy with your stocks. This calls for real expertise. Hence, don't go buying stocks directly. Make sure to invest through high-quality mutual funds, with proven record of long-term performance.

Third, you have to have at least 5-7 years of investment perspective. Anything less and you could be seriously disappointed with the results.

Fourth, you need to tone down your expectations. I have seen people desiring 30-50% p.a. returns (and more) from equity. This is clearly not possible. It's not a desire, it's a delusion. Tax-free returns of 12-15% p.a. are, in most cases, good enough to realize most of the normal needs and desires. You could fall flat and hurt yourself, if you aim to Get-Rich-Quick.

Last but not the least, don't look for hindsight or foresight; just keep straight sight. Choose your investment options with great thought and care... and become a disciplined investor continuing with your SIPs, without any break.

Concluding: Timing the markets consistently is impossible. Given the unpredictable nature of the Stock Markets, you simply never know when to stop and when to start investing in equity. Many studies also prove this point (See: Two biggest equity investing myths shattered). So, just follow the above basic rules of investing in the stock markets — and wait to become a millionaire.

An Investment In Knowledge Pays The Best Interest ~ Benjamin Franklin

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