The stock market's 50% rise since March means that many investors have become increasingly optimistic about its future prospects.
However, in my opinion, copying the bullish sentiment of your peers or trying to predict the stock market's future direction based on its recent performance may be a dangerous strategy.
A better idea could be to follow Benjamin Graham's contrarian stance. His ability to ignore the views of other investors and base investment decisions on fundamentals, rather than sentiment, may be key reasons for his long-term outperformance of the stock market.
Avoiding overvalued stocks after a recent rise
A rising stock market may naturally prompt some investors to buy more stocks. They may feel that recent upward trends will continue, and that the stock market's momentum can carry it to even higher levels.
However, in my view, rising stock prices represent a less attractive investment opportunity compared to falling stock prices. There may be narrower margins of safety on offer in a bull market than in a bear market, with rich company valuations potentially meaning higher risks and lower capital growth prospects.
Therefore, a more cautious standpoint that avoids overvalued stocks may allow you to allocate capital more efficiently. It may go against the market consensus view, but could lead to the avoidance of unnecessary risks.
As Graham once said, "The one principle that applies to nearly all these so-called 'technical approaches' is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success in Wall Street."
Relying on company fundamentals
Even though some stocks may be overvalued at the moment, there are also others that could represent buying opportunities.
For instance, those stocks that operate in sectors facing uncertain operating conditions could be more appealing than their current low valuations suggest. They may have minimal leverage, an economic moat and a strategy that can help them adjust to changing market conditions.
Buying unpopular stocks with difficult short-term outlooks can take a large amount of self-discipline. However, where a company's fundamentals are strong, ignoring the negative sentiments of your peers and buying it could be an efficient use of your capital.
As Graham previously said, "Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgement is sound, act on it – even though others may hesitate or differ."
Using history as a guide
The stock market's past performance shows that bull markets and bear markets do not last forever. Therefore, over-optimism amid rising prices, as well as a pessimistic attitude when stocks are falling, may not allow you to manage your portfolio effectively for the long run.
Likewise, the difficult trading conditions being experienced by some companies are unlikely to last forever based on the economy's past recoveries from recessions and depressions.
Despite this, investors can have short memories. They may adopt a short-term standpoint when it is much more beneficial to view capital allocation from a long-term perspective.
Graham always sought to gain an advantage over his peers by adopting a long-term outlook. As he once said when referring to the short-termism of his peers, "The memory of the financial community is proverbially and distressingly short."
Read more here:
- Seth Klarman: 3 Reasons to Be Cautious in Bull Markets
- Peter Lynch: 3 Common Investing Mistakes to Avoid
- Howard Marks: Contrarian Investing Can Beat the Stock Market
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