Avoid popular stocks
Lynch managed Fidelity’s Magellan Fund from 1977 to 1990 and delivered a stunning 29.2% compounded annual growth rate. That was double the S&P 500’s performance over the same period, which cemented his reputation as one of the best investors in market history.
The S&P 500 surged tremendously after Lynch retired. In a rare interview with Charlie Rose in 1997, he talked about how investors can navigate such conditions. “If the market goes too high you’re discounting earnings seven, eight, 10 years out,” he said. “That doesn’t help anything.”
Lynch told Rose that the stock market’s price-to-earnings (P/E) ratio had fluctuated from 10 to 20 since the end of WWII. And if the valuation was closer to the upper end of that range, it was overvalued and investors should be cautious.
Recent data backs his theory. Economist Robert Shiller shared data in his book “Irrational Exuberance” that indicates that the S&P 500’s historic average P/E multiple is 16.07. As of June, the multiple sits at 27.79 — far higher than historic average and the upper-end of Lynch’s preferred range.
In other words, the market is overvalued right now. In these conditions, Lynch believes a correction is “healthy” and investors should avoid frothy, overpriced stocks. This is because he says overvalued stocks offer a poor risk-reward ratio.
“You have to say to yourself, ‘If I’m right, how much am I going to make? If I’m wrong, how much am I going to lose?’” he explained to Rose. “[With overvalued stocks] if I’m right the stock is not going to go up. It’s already discounting terrific things. If discounting terrific things is already in the stock I don’t want to own ’em.”
In other words, the most popular stocks are likely to be priced to perfection. Even if they meet elevated expectations, the potential reward is too slim to justify the risk.
Instead of focusing on these popular stocks, Lynch recommends keeping a close eye on lesser-known niche stocks that are fairly valued.
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Read MoreWait for fair deals on niche stocks
Lynch believes the best tactic in an overvalued market is to wait and watch a handful of stocks that you already like and understand deeply.
“You’re trying to find companies you like anyway,” he said. “Right now you like them and now they’ve had a haircut. That’s what we do. Not a stock that went from overpriced to fairly priced but something that was fairly priced at the start of this exercise and then had a five-for-four sale.”
Lynch built his career on picking out stocks that were ignored or overlooked by Wall Street analysts. Similarly, he recommends deeply researching companies and stocks that are within your circle of competence and below the radar of most analysts and professionals. A farmer, for instance, would have unique insights into commodity prices while an actor would understand streaming platforms and movie studios better than ordinary investors.
“You have to have a niche,” he sums up.
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