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How to face an overvalued stock market? TOPIC: RISK

The crash in March was one of the most significant blows that hit the stock market after the 2008 -recession. Since then, there have been ups and downs but never a sharp fall as deep as the one in March.

Several experts believe the stock market is not in sync with the economy. Consumer spending has fallen, and global GDP has declined significantly in Q2. Given this, overvaluation is a hot topic in the last months.

What is overvaluation about?

An overvalued stock has a current price that is not justified by its earnings outlook, typically assessed by price-earnings (P/E) ratio, which is the most popular measure of a company's financial strength as analyses a company's earnings to its stock price. However, there are various valuation indicators like PB Ratio, Dividend Yield, GDP to Market Capitalization, PE to Growth Ratio, Bond Equity Earnings Yield etc.

Where does the overvaluation come from?

Overvaluation may result from an uptick in emotional trading, or illogical, gut-driven decision making that artificially inflates the stock's market price. Overvaluation can also occur due to deterioration in a company's fundamentals and financial strength. To judge the right valuation of equity market, an investor can compare current PE Ratio with average or fair level of PE Ratio. So, if current PE Ratio is 24 and fair level of PE Ratio is 20 then it can be said that equity market is overvalued by 20%.

How an investor may behave?

Economic experts expect the price to drop eventually. Thus, overvalued securities are good “sell” opportunities. As a matter of fact, this category of securities is sought by investors looking to short a position, selling shares to repurchase them when the price falls back in line with the market. Therefore, this behaviour takes place because overvalued stocks trade at a market price that is significantly higher than their fair value (market value > fair value) as a result of increasing investor confidence or biased consensus estimates.

For a better understanding let’s make a simple example. Assume a company has a stock price of $100 and earnings per share of $4. The calculation of its P/E ratio is determined by dividing the price by the earnings $100/$4 = 25. So, in this example, the security is trading at 25 times earnings. If that same company has a bumper year and makes $10 in EPS, the new P/E ratio is $100/$10 = 10. Experts consider the company overvalued if earnings are $4 per share but undervalued if earnings are $10 per share.

With that in mind, according to yahoo finance there are 7 overvalued stocks investors should sell for October: Tesla (NASDAQ:TSLA); Workhorse (NASDAQ:WKHS; Apple (NASDAQ: AAPL); Zoom (NASDAQ:ZM); Beyond Meat (NASDAQ:BYND); Moderna (NASDAQ:MRNA); American Airlines (NASDAQ:AAL).

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Autore: Beatrisa Pucalev, Asset Management, Risk Junior Associate

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