Many investors and traders are looking at the market and wondering how in the heck they can continue higher. A lot of the frenzy is being driven by overbought and overvalued stocks. (This is very different from overbought or oversold markets, which I cover here.)
Just look at Tesla. This stock has soared to crazy levels and refuses to come down (and it has made Elon Musk the richest man in the world). On the other hand, stocks that were all but discarded have suddenly been resurrected by massive money flows.
You may be shaking your head at the craziness. Maybe you’re decided to pass on trading while cursing the ridiculous state of the markets. Well, the markets don’t really care what you think. Overbought stocks can remain overbought for quite some time. However, overvalued stocks are likely to correct sooner and swifter than overbought stocks. Make sense? Probably not, but let’s try to explain it.
Overbought vs overvalued stocks
An overbought stock is not a fundamental concern. It simply means that investors and traders have been piling into a name for various reasons, such as strong momentum, relative strength and high volume/price breakouts. If there’s one thing that pushes stocks beyond reason, it’s momentum. Tesla is one of the most overbought stocks we’ve ever seen – and it’s been like that for weeks.
Trying to call a top on an overbought stock is simply a guessing game. You’ll be exceedingly lucky if you nail it. Overbought stocks can run for awhile, whether or not it makes sense. As John Maynard Keynes once said, “Markets can remain irrational longer than you can remain solvent.”
An overvalued stock sports a price that is not supported by its earnings outlook or price-earnings (P/E) ratio. It becomes overvalued when too much hype, followed by too much money, drives the price higher. Here’s another way to look at it: an investor pays a certain amount for a dollar of earnings. This is called a multiple. When that level is higher than normal (or its peers), the stock is selling at a premium multiple.
Eventually, the law of large numbers catches up to overvalued stocks. Once it’s clear that companies cannot produce a high level of earnings for investors, they retreat from the stock until there is an appropriate multiple vs earnings. This retreat can be swift and painful.
If you’re investing for the long term, wait for stocks to recover from overvalued status. It can work to your advantage. If you’re trading stocks, you could conceivably pile into a hot, overbought trend. Just be ready when the music stops – that is where you might get hurt.