Why are people still investing in stocks or indexes which are obviously overbought?

Question

I have some life savings I want to invest. My first idea was to buy a flat or home - but the current price levels for houses and flats in my country are beyond insane because of the money policy of the European Central Bank (cheap loans). Instead, I now want to put that money into the Stock market (ETF or single stocks). However, it seems that the situation in the stock market is also looking like everything is overbought, I mean just look at the current S&P500 graph for example.

Or the German DAX. This looks exactly like the 2017s Bitcoin Bubble before it completely went from 20.000 to 3.000 over the course of the next year. How is anyone looking at this S&P500 graph and thinking "this is sure a good idea to invest"?

Answer 1

What about that graph today is different from that graph would have been 6 months ago? People 6 months ago bought thinking it would still go up, and it has. That's why people are buying today. That's what you asked. They may be right, they may be wrong, but that's why they are buying.

Further, they may be buying because they have few other options. If interest-bearing instruments and real estate are not good choices, people turn to the stock market. And as long as more people keep turning to the stock market, those who need to sell for whatever reason will find someone to sell to -- at a profit.

Answer 2

I deny your assertion that that market is overbought, and have a graph to lend credence to my assertion.

Answer 3

What's the alternative? Bonds? Interest rates are at historic lows in most developed areas. Commodities? Energy prices are relatively low and have enormous volatility (remember the oil spike a few weeks ago after the US-Iraq dust-up? That's gone now). Mattresses? You actually lose value due to inflation.

I don't know that people are saying that "it's a good idea to invest in equities" because the market is cheap. It's because it's still one of the best investments in terms of risk vs. reward.

Will there be a correction or even a crash? Possibly, but you and I have no idea when that will happen or how big it might be. Even if there is, historically the market has recovered in a few years with very rare exceptions. So if you have a long investment horizon (e.g. retirement for a young person or college savings for new parents) then you can weather the ups and down of the equity market and will almost certainly come out ahead in the long run.

Answer 4

1: Don't time the market

As the saying goes "time in the market beats timing the market". If you have money to invest, investing the money will yield better results than not investing the money. Unless you know a crash is coming (in which case why would you tell us instead of making your billions) you should be investing.

2: Why would you conclude that the market is crashing ?

There's many really good investors who make it clear that they can't predict a stock market crash. Why would you conclude that you're better than all of them (combined) ?

3: Over the long term the market goes up

Despite the crashes. There's not a single point in time at which it wasn't better to invest than not to invest. So unless you sell your securities at a worse price than you bought them for you will make money (disclaimer: unless you buy companies at risk of going bankrupt in the next few years).

4: What's the alternative ?

As others have pointed out there aren't a whole lot of other options. You don't want to buy stocks, you don't want to buy real estate. You could buy bonds, you could just put the money into a savings account (for a loss to inflation).

5: You could pick individual stocks

You said "everything is overbought" which is not true. On average the market is pretty high, but that doesn't mean that there aren't companies that are cheap right now. There's quite a few companies that have a pretty solid dividend and a reasonable P/E.
Disclaimer: You need to be a better investor than the market as a whole. Most investors won't beat the market. It is extremely hard to beat the S&P500 by picking stocks. Just go with index funds if you're not 100% sure what you're doing and comfortable with losing money and/or not beating the S&P500.

Answer 5

Easy.

Stocks are expensive. So are you going to invest to bonds?

Bonds are expensive too. The interest rates of bonds are near to zero in Eurozone and low in US too.

If stocks normally offer 3% real growth + 2% inflation = 5% nominal growth and 4% dividend, i.e. 9% total return, and now the dividend yield has fallen to 2%, the total return in current market conditions is 3% real growth + 2% inflation + 2% dividend yield = 7%. Only 2% lower than usually.

I think you'll find that bond yields are 2% lower than usual, too.

There's no such a thing as a free lunch. By claiming you should not invest into stocks, you are claiming there is an option whose risk-return relationship is better. Such an option would be a free lunch. There's no such a thing as a free lunch.

Answer 6

In part it's the bandwagon effect. People tend to do things, whether it's investing in apparently overpriced stocks or buying Beanie Babies* in hopes of selling them at a profit, not because they have rationally analyzed the risks & rewards, but because lots of other people are doing it.

So we hear lots of news (and proclamations from certain politicians) about how the stock market keeps going up, and so people who hadn't invested before decide they're going to start investing in the market too, because it's bound to keep going up, isn't it? That means the prices of stocks keep rising, because more people want to buy them.

Unfortunately, the market always collapses eventually. If the bubble is in something that has little or no inherent worth, like Beanie Babies or derivatives, it stays collapsed. With things than have inherent worth, like stocks, the market tends to drop to below inherent worth, then rebound to that level and grow slowly until the next cycle starts.

*Or bitcoins, or tulip bulbs, if you happen to have lived in Holland in the 17th century: https://en.wikipedia.org/wiki/Tulip_mania

Answer 7

An investor, who is interested in the stock market indexes but thinks that they are too high, could take inverse positions. However, the long-term stock-market trend is upward so an inverse position would be an attempt to catch a short-term trend.

Or the investor could take long positions in the indexes and write covered-calls on the indexes. But note that a hedge of the underlying position could be a large loss in an uptrend because the short-calls will have given up most of the upside of the underlying position. So a hedge needs a price point of the underlying position where the hedge is closed out.

Basically, if the investor thinks that the stock market indexes are too high then the investor can sell calls to investors that think the market is going higher.

But why are ordinary investment positions continuing to invest at high price levels ? Well, the indexes re-balance such that declining stocks are reduced in the index. This re-balancing of the indexes has produced recent years' triple tops as the indexes re-balanced and rode the new balances back up. To beat the logic of the stock indexes then everything has to go down.

Answer 8

Every now and then, you'll see a news article declare that some index or exchange has reached a new record high. It would be easy to say: "Well, clearly, that means it's a bad time to buy into the market." Except there's one problem with that thinking: over the long term, pretty much every major market grows without bound. That means that said markets must reach new record highs on a regular basis.

Markets grow partly because inflation devalues the currency used to buy shares, but mostly because the companies comprising the markets simply get better at what they are doing over time, just like people often do. That is, the market grows about 2-3x as fast as inflation, over the long run. Which means, looking at the market itself to decide whether it's overbought is not a strong idea, as others have noted.

The only way to confidently assert that it's overbought is to show a better alternative. That is, if you have an investment option that is offering better risk/reward, then simply share it with us. Until then, your "investment sheeple" are acting more rationally than you might care to admit.

Answer 9

Investors act because they expect a return on their money. This is true in overbought sectors, where 'momentum' and the 'next greater fool' comes into play.

Bulls make money
Bears make money
(Greed) Pigs are slaughtered. 
- Jim Cramer