How to Invest in an Overpriced Market

What should an investor do when all asset classes appear overpriced? The 10-year US treasury Bond yields about 2.6% which is much lower than the 5% historical average and only slightly higher than the Federal Reserve's 2% inflation rate target. S&P 500 Index has recorded new all-time highs, Hang Seng Index was at a new record high in January 2018 and even laggard Straits Times Index is close to all time high of 3800.

The cycle adjusted price/earnings ratio (CAPE) - the valuation metric which predicts future 10 year rate of return is about 34. That's one of the highest valuation exceeding only readings in 1929 and early 2000, prior to crashes. Today's CAPE suggests that 10 year equity rate of return will be barely positive. Do you believe that this time it will be different?

A corollary is that no one can consistently time the market. Proper market timing involves making two decisions - when to get out and when to get back in. Timing both correctly is virtually impossible. Investors who try to outsmart the market more often get it wrong than right.
What can an investor do to minimize this risk? Here are some options:

Rebalance 
A simple portfolio that started out 2009 with 60 percent in US stocks and 40 percent in US bonds would now have close to 80 percent in stocks and 20 percent in bonds. You can rebalance and set target asset allocation weights and periodically rebalance back to your preset amounts on occasion.

Overbalance
If you are worried about stocks, you can shift money to underperforming assets. Value stocks have underperformed growth stocks by more than 3 percentage points annually over the last decade. US stocks have outperformed International stocks which include European stocks and emerging markets over the same intervals. Hence, investors looking at mean reversion could allocate more of their portfolios to value and international stocks.

Avoid complexity and shift to Cash/Bonds
There are plenty of complex hedging techniques available but require incredible foresight to work. It is difficult to time the trades, volatility and costs can eat into your returns. The easiest way is to simply take less risk by raising more cash or invest in high quality bonds and lesser equities. By holding enough cash on hand will give you the peace of mind in knowing you can meet your expenses in a downturn is worth more than a few percentage points in returns. This money is your war chest which you can use in the next round of downturn.

Buy and Hold
Being a long term investor is easy when the market price is going up but when it is coming down, it is a test of grit and temperament. Beside been emotionally challenging, it is a great way to avoid transaction cost and market timing errors.

Use momentum
Momentum is based on the idea that asset that performs well will continue to perform well and vice versa for a short period of time because market is irrational in the short run.

Diversification
Staying the course in a broadly diversified portfolio is the best strategy when all asset classes appear overpriced. If rebalancing is required to constrain portfolio risk, consider good quality dividend stocks. With a yield of about 5%, it offers some return even when the market turns against you.

Each of these approaches has its own drawbacks and limitations. The best investment strategy is one which will suit your temperament and you stick to it.