Investor sentiment has improved significantly since the stock market reached a three-year low in March. The S&P 500 has gained around 50% in just over six months, with many stocks now trading on rich valuations.
However, in my opinion, adopting a cautious mindset in the current bull market could be a prudent approach. The economic and political outlook is uncertain. This could cause investor sentiment to change.
Baupost co-founder Seth Klarman (Trades, Portfolio) has previously sought to remain cautious when other investors have been optimistic. His long-term approach and focus on company valuations may be key reasons for his consistent outperformance of the stock market.
High valuations
The valuations of some stocks have moved to extremely high levels in recent months. Frequently, investors seek to justify them by using optimistic forecasts that suggest some companies are set to deliver exceptional levels of profit growth despite a weak economic outlook.
However, relying on optimistic forecasts when buying any stock can be a dangerous strategy. It is impossible to accurately predict the prospects for any business in future due to the range of variables that can affect financial performance.
Therefore, it may be more prudent to allocate capital to stocks that currently trade at a discount to their intrinsic values. Their margins of safety may provide some protection over the long run against an uncertain geopolitical outlook that could cause growth rates to disappoint versus expectations.
As Klarman once said, "Overvaluation is not always apparent to investors, analysts, or managements. Since security prices reflect investors' perception of reality and not necessarily reality itself, overvaluation may persist for a long time."
Following other investors
A key reason for the stock market's recent recovery has been the increasing popularity of large-cap technology stocks. For instance, Apple (AAPL, Financial)'s share price has gained 50% this year. Likewise, Facebook (FB, Financial) is up 20% since the start of 2020.
Even though those businesses are delivering improving performances, investor sentiment has increased to extreme levels. For example, Apple has a price-earnings ratio of 35, while Facebook's price-earnings ratio currently stands at 31.
In my opinion, there are always new investor trends that mean some stocks are in vogue. For example, one industry or one type of business can become extremely sought-after among investors for a period of time. This can be a dangerous situation for investors who follow their peers and buy popular stocks when they trade at high prices.
As Klarman has previously said, "We may confidently expect that there will be new investment fads in the future. They too will expand beyond the rational limitations of the innovation."
A long-term outlook
The stock market's recent gains could conceivably continue in the short run. However, they are extremely unlikely to persist over the long run. The longest bull market in history lasted for around 13 years between 1987 and 2000, while the average length of a bull market is around three years. Therefore, the current bull run will eventually be replaced by a bear market.
Planning for falling stock prices may mean that you underperform a rising market in the short run. However, ensuring that your holdings have market valuations that reflect their underlying values may lead to a more efficient capital allocation. They could be less affected by a declining stock market, and may outperform today's richly-valued stocks over the long run.
Klarman has always taken a long-term view when managing his portfolio. As he once said, "Many of the forces that cause securities prices to depart from underlying value are temporary."
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Peter Lynch: 3 Common Investing Mistakes to Avoid
- Howard Marks: Contrarian Investing Can Beat the Stock Market
- Charlie Munger: Self-Discipline Is Crucial to Investment Success
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