Current Top Performing Stock Funds Often Have One Big Problem

In attempting to help investors achieve excellent returns, a frequent theme in my Newsletters has been to remain vigilant for instances in which otherwise excellent funds seem to have become "overvalued." If a given fund can be classified as overvalued, the chances are that, sooner or later, its returns will tend to underperform a fund that is not currently overvalued, or, is even undervalued. This is the same principle that applies to the stock market as a whole: If the stock market is overvalued, sooner or later, it can be expected to underperform. Of course, the phrase "sooner or later," being as inexact as it is, likely tends to cloud the essential truth. So long as an overvalued fund, or, the overall market, keeps going up, which they often do, many investors are willing to take their chances, riding the positive momentum, all the while putting the risks on the back burner.

Another way of looking at it is this: Fund or stock market performance moves toward the future on two different tracks. In the relatively shorter term, the best predictor of performance is a continuation of the same magnitude of performance (that is, over- or under-) it has been showing in over the last several years. However, in the relatively longer term, the best predictor of performance is indeed valuation, with overvalued assets likely to underperform and undervalued ones more likely to do better performance-wise.

While the term "overvaluation" is essentially a conceptual one, with no one absolute definition, there are certainly some guideposts that can point in the direction of overvaluation that investors can make use of. One easy one to spot is merely realizing that stocks have gone up, on average, by greater than 15% annualized over a period of 5 years or more. This information is available and updated regularly on morningstar.com.

As recently as the summer 2014, stocks were averaging even bigger gains, that is, 20% per year annualized, over the prior 5 year period. Since then, stocks have slowed the pace, but not by an extreme amount, with major indices averaging about 13% a year over the last 5 years. But the "slowdown" has been enough to perhaps say that stocks are now "only" in the upper range of what might still be considered "fair" valuation, and therefore, perhaps not quite as overvalued as before.

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Disclosure: I do not wish to recommend neither BUY, SELL, or HOLD for the 5 mutual funds nor 4 ETFs mentioned in my article entitled “Why Staying Fully Invested In Your ...

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