The current market environment presents a unique challenge for investors. It is unlike anything we've ever seen before.
Many of the world's largest economies experienced their biggest economic contraction on record during the second quarter of 2020. However, despite this, the stock market has just printed a new all-time high. The rally is being driven by tech stocks, which have surged in value this year.
Buying tech stocks
To some extent, it's clear why investors have rushed to buy tech stocks in 2020. The coronavirus pandemic has forced millions of people out of their offices, and the demand for remote working tools such as Zoom (ZM, Financial) has never been higher.
That being said, many of these companies are now trading at nosebleed valuations. For example, after its recent performance, Zoom stock is trading at a forward price-earnings multiple of nearly 300. Is this justifiable? It is unlikely, but at the same time, it is not entirely impossible to see earnings rise to a level where the current valuation would be justified.
This is just one example of the dilemma investors face. Zoom is a valuable tool for the working world, and the stock could continue to rise. There are plenty of examples of tech stocks that have commanded similarly high valuations and have grown into them. That does not mean the stock is a good investment at current levels, although the company is one of a handful of tech stocks that have produced the majority of the market's positive performance in 2020.
So investors face a dilemma: either buy expensive tech stocks and hope they continue to go higher or stick with languishing old-world and cheap companies, which may or may not have a future in the post-Covid world.
There is one simple answer to this dilemma, in my opinion: buying an index tracker fund. Considering the level of uncertainty facing the global economy, I think this may be the better strategy for most investors as compared to stock-picking.
We don't know what the economy will look like 12 months from now, and we certainly don't know which companies will win. There are also political risks to consider with the U.S. election coming up in November.
The other option is to stay away from highly valued companies altogether. These companies appear to be drawing in all of the market's capital at the moment, but there are plenty of other high-quality stocks on the market that are just not getting the same attention.
Learning from history
There are two periods in recent market history which have similarities to the current environment. Those are 1999 and 2006, the dot-com bubble and the pre-financial crisis period. During both of these events, the valuations of highly sought-after stocks exploded, while unloved equities' values plunged.
The well-known investors that fared best in these situations followed similar strategies. Investors such as Warren Buffett (Trades, Portfolio), Seth Klarman (Trades, Portfolio) and Howard Marks (Trades, Portfolio) didn't get involved in the speculative mania. Instead, they allowed their cash balance to grow while waiting for the perfect opportunities to arrive. Reading through their investor letters of 1999 and 2006, none of these three experienced investors tried to argue with the market. They thought a bubble was growing, but didn't try and bet against it or sell everything. They let it run its course. Rather than trying to time the market, they bought stocks when they fell to attractive levels and stayed in cash when there was nothing to buy.
A similar approach may work in today's market. We don't know what the future holds for the global economy and the stock market. However, we do know that buying high-quality companies at attractive prices yields positive returns over the long run.
It seems sensible to concentrate what we do know, rather than what we don't. If nothing attractive emerges, it could be better to sit out the rally.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Why Warren Buffett's Japan Bet Is a Great Deal for Berkshire's Investors
- Warren Buffett on Why Buybacks Can Be a Good Deal at High Prices
- Learning from LTCM and Warren Buffett
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