Currency Wars: “Beggar Thy Neighbor” Policy
February 12, 2025
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All stock market investors know that markets go through periods of euphoria and panic. During periods of euphoria, investors keep on buying shares in the hope of a higher payoff. In technical terms, this is the situation wherein the entire market becomes overvalued. The opposite of this also happens when fear grips the market, everybody starts selling all their shares and the market becomes undervalued.
The problem is that overvalued and undervalued markets are normally seen in hindsight. Most investors believe that the market that they are in at the present moment is fairly valued. If the market is overvalued, experts often come up with theories that suggest why this time it is different and why overvalued markets are going to be the new norm. Hence, if an investor is genuinely able to ascertain whether or not a particular market is overvalued, they have a definite edge over the others in the marketplace.
In this article, we will have a closer look at some of the factors that help investors identify overvalued markets.
An overvalued market can be identified by making comparisons with the right frame of reference.
A weighted average of the price earnings ratio of the companies that make up the index is used to calculate the price-earnings index of the entire market.
Generally, the price-earnings index stays around the mean. This means that if you calculate the price earnings ratio based on historical data, the average is the normal Price Earnings ratio.
Hence, if the present P/E is much greater than the historical average, then the market is overvalued. This is exactly what happened in the case of the Great Depression, the dot com bubble as well as the Great Recession of 2008.
If this ratio falls below 0.7 or so, it could mean that the market is undervalued and could provide a buying opportunity.
On the other hand, if this ratio crosses above 1.25, the market is said to be overvalued.
The problem is that the numbers required to calculate this ratio are not available to the general public. However, there is a workaround. Neutral organizations like the World Bank keep on publishing this data every quarter. This number does not really change too much every day. Hence, a quarterly frequency is good enough.
To sum it up, the two metrics mentioned above do provide a mechanism to identify overvalued and undervalued markets. However, it needs to be understood that the recommendations cannot really be blindly followed. This is because there may be other factors involved too. Hence a thorough understanding of such factors is necessary before making any investment decisions.
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