The Standard & Poor 500 Index has reached an all-time high and investors wonder if this means stocks are overvalued. Should you sell?
Knowing when to sell is the ultimate challenge for many stock investors. We hesitate to take a loss, hoping the stock will recover, and we hate to sell our winners, thinking we haven’t seen the top. It is relatively easy to buy. You hear a good story, the stock looks “cheap”, the market is down and sentiment for stocks is strong.
How do you know when to sell? History has proven that losses are hard to recoup so it is best to avoid mistakes and take a disciplined approach to investing. Emotions are your enemy when it comes to investing. We often regret too much cash when the market is rising and we wish for more after a market decline. Today, pundits tell us the market is expensive. What does this mean? Here are some things to consider that will help in the decision to hold or sell:
Asset Allocation
Set a long-term target or range for the percentage in stocks that will produce the most return without taking more risk than you are comfortable taking. The younger you are the more you can live through and survive market declines. Stocks are the best long-term investment, even after the declines we’ve experienced this decade. Stock prices today are at the highest point in history after two severe market declines in 2000 and 2008. If you are young and don’t need the funds it is usually best to ride it through. Market timing does not work. It is almost always a mistake to sell all your stocks, thinking the market will drop. The stock market may not decline or you may miss the low point and not get back in.
A modest adjustment to the amount in stocks makes sense. Review where you are against your target to be sure your positioning is a conscious decision to either own more or less stocks. In 1999 investors got carried away, thinking it was different and stocks, especially technology shares, were destined to go even higher. Investors let the market carry their percentage in stocks well above their target, ignoring the risk of a market correction. Rebalancing back to your target prevents losses and provides discipline. If you are fearful of stocks, regardless of your age, set a lower target but do own some stocks. If you are retiring and may need to liquidate assets to live, own less. You also need to look at the relative returns from the various types of investments. For example, cash now yields almost zero and bonds are very low yielding. Stocks have been the highest returning asset class and the best game in town – the reason investors are reluctant to sell. Rebalancing is not market timing. It is a disciplined way to limit risk.
Reducing Stocks
It is very difficult, especially now, to make a broad market call. While the overall price/earnings ratio on the market is above average, there are many sectors and individual companies that have not participated in this rally. The market could continue to move higher if the economy is strong and interest rates do not rise materially. It doesn’t hurt to trim stocks that have done well.
Let’s assume you are over your targeted amount in stocks, have made money these past six years and think it’s time to sell. You may consider selling a piece of every holding. This doesn’t make sense if all holdings have not appreciated. So, how do you know what stocks to sell? You could go down the list and sell the ones that have produced the most gains. This doesn’t say anything about the reason for the gains or the likelihood the stock is overvalued and other investors are about to agree with you and sell.
We have provided a table of some randomly selected companies that look richly priced on first glance. They have all done well, advancing with or more than the S&P 500 since 2009. We compare the information on each stock to the index, with a price at 18.84X earnings. The market is trading above the 10 year average P/E ratio.
The price earnings ratio is a way to look at the price of a company’s stock relative to what it is earning. The higher the number the more you are paying for each dollar of earnings. You can then look at the current number and compare it to the 10 year average P/E for the company. This isn’t a perfect sell indicator but it does put the current price in a historical context. These figures are available for most companies on Morningstar.com under the “ratios” tab. If a stock is trading well above its average P/E ratio then you can next look at the growth in earnings. If earnings are growing double digit the “e” part of the equation may support the stock at current prices. What you want to watch for are stocks with high P/E ratios relative to their historical average and the market P/E and not supported by the earnings growth rate.
Looking at the chart above, it is clear that all of these companies are trading at a price/earnings ratio above the market and their respective 10 year average price/earnings ratios. If earnings grow with the increases in stock prices, this multiple won’t change or expand. On the far right of the table is the estimated growth rate in earnings for 2016 vs. 2015. Smuckers is a good example of a company trading at a higher price/earnings ratio than the market with an earnings growth rate below the market. If you have gains in a stock like this it might make sense to trim the holding and take profits. Smuckers is a quality company but the stock price may have moved ahead of fundamentals. Any disappointment in earnings could mean a decline in the price and if the market does sell off it is these richly valued companies that investors will sell first.
This exercise assumes the company is on solid ground from a fundamental standpoint. It is important to sell, regardless of the market, if a company is in trouble and the fundamentals are deteriorating. A good example of this was the oil spill in the Gulf of Mexico. British Petroleum and Transocean faced massive fines and litigation as well as business interruption. Many investors felt the risk to holding these stocks was not warranted and sold their positions.
Selling stocks means that the proceeds will be invested elsewhere. Cash is an investment. In many instances the dividend yield on a stock is greater than the return from cash, bonds or other investments. This has to be factored in when deciding to sell. It is the consideration of all factors, not just price, that will determine whether trimming a holding or selling the position is warranted. It may be that a conscious decision to hold a stock that looks expensive is the right thing to do. It is easier to weather a downturn if some discipline is applied before the market or stocks moves lower. There are then no surprises.
Taxes
Many individuals hold stocks in their retirement plans such as their IRAs or 401ks. Capital gains taxes are not a factor. However, if stocks are held in a brokerage account or trust it may be costly to sell. Capital gains are taxed at a lower rate than income, unless the stock hasn’t been held for a year. A capital gain is the difference between the amount you paid for a stock and the sale price. If you work with a tax advisor it may make sense to touch base with him or her before selling. Taxes are a complex subject and should be factored in when considering sale. However, don’t let taxes drive your investment decisions. The goal in buying stocks is to make money – no harm in realizing gains if you are aware of the amount and can plan for the added tax.
Mutual Funds
Mutual funds are a portfolio of assets, such as stocks or bonds. It is difficult to look at each individual holding in a mutual fund and know whether or not the fund is overvalued. If you look up the fund on Morningstar they will most likely have a report on the fund’s performance and underlying valuation. Many investors can’t name the funds they own, much less what assets are held in the funds. We have had six years of gains for both stocks and bonds. At some point it will matter which funds you own. Read as much as you can about each fund. Index funds are an option but again, this is a collection of assets. If investors panic and decide to sell then fund managers have to raise cash as shares are redeemed. This can cause the fund to decline even further.
The good news is that markets always recover. An option is to hold your positions, know that stock prices fluctuate and decide not to panic if prices move lower. Modest trimming makes sense, keeping taxes in mind. Unfortunately, individuals get scared and often sell too late. Taking a look at your profits and trimming some winners may make sense while the stock market is still high.