5 Reasons the Stock Market is Over-valued

Last Updated Jan 19, 2011 9:57 AM EST

I have a very uneasy feeling about the stock market right now. Here are some reasons why I'm nervous and, though I'm not one to time the stock market, what I recommend doing about it.

1. Stocks have recovered - the economy hasn't
The US stock market is within 2.3 percentage points of the 2007 year-end close, which was the highest year-end close in the history of the stock market. Yet we also have 9.4 percent unemployment, and the deficit at levels unimaginable only a few years ago. Our growth prospects today seem far less than they did in the go-go years.

2. Prices have increased 106 percent
Stocks were having a fire sale back in March 2009. Since their low, Wall Street has increased the price of US stocks 106 percent. It was the bargain of the century, so far, but few were recommending buying stocks during this great sale. I've done the analysis, and guess what? It's better to buy stocks when they are on sale than after prices double. I'll even show my work!

3. The experts predict a great 2011
A corollary to number 2 above is that the experts seem to nearly unanimously agree that stocks will increase by about 20 percent this year. That those are the same experts that were pessimistic about the stock market in early 2009, and usually call things wrong, gives me pause. I haven't seen so much optimism from the experts since they predicted a good 2008.

As January goes, so goes the market for the year, according to the January Barometer. Well, January is looking pretty good. The problem is that all of these patterns tend to work much better in the past than the future. In fact, the January Barometer was wrong last year.

Such unbridled optimism historically ends up being the canary in the coal mine.

4. Money is finally flowing into stocks
According to the Investment Company Institute, investors are finally putting money back into stock mutual funds. One of my key indicators for investments is based on the fact that investors as a whole typically time investments wrong. After all, they poured money into mutual funds in 2007, took funds out in droves in 2008 and 2009 after the bottom fell out, and are now going back in. This indicator in particular has me running for the Rolaids.

5. Bonds are scary
Bonds are the main alternative to stocks and, with rates so low, bonds simply can't continue their past gains. I've been beating the drum for awhile that the bond party is over. Bonds prices have declined and the fear over muni bonds is immense. I've had people tell me that bonds are riskier than stocks right now. I can assure you, however, that stocks as a whole, are always riskier than bonds.

All five of the above factors make me nervous. Nonetheless, I was nervous in 2005 and 2006 when the markets kept going and going like the Energizer Bunny.

My Advice
Recognizing, as I do, that I don't know what the market will return in 2011, I'm not recommending that everybody should get out of the stock market. Though I do have a couple of key take-aways:

  1. Rebalance! Your equity allocation has increased as a result of one of the greatest bull markets in history. Human tendency will be to let it ride and you need to fight that tendency. Sell equities to get back to an earlier, more conservative, allocation.
  2. Don't get into the market now. If you are thinking about increasing your equity positions, you are being driven by human emotions and not logic. Don't do it!
Adopt a more contrarian approach and stop following the herd, if for no other reason than herds get slaughtered. Remember the pain of the last plunge. But, more importantly, learn from it.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.