The S&P 500 has reached an all-time high this year. However, even though its recent momentum may be strong, no bull market has lasted forever.
Therefore, in my opinion, adopting a prudent approach towards stock valuations and preparing for the next bear market could be an efficient use of your time.
Oaktree Capital cofounder Howard Marks (Trades, Portfolio) has always sought to avoid overvalued stocks that are based on overzealous forecasts during a bull market. This may be a key reason for his long-term outperformance of the stock market.
Following market cycles
It is tempting to join other investors in believing that stock prices can move higher forever. Any investor who sits out a bull market is likely to find the short-term opportunity cost of holding cash or bonds a difficult experience. Today's low interest rates and the stock market's rapid rise are likely to make this situation even more acute than is normally the case.
However, the past performance of the S&P 500 shows that no bull market has ever lasted for more than the 13 years experienced between 1987 and 2000. The average bull market lasts for around a fifth of that time. Therefore, a bear market is almost certain to take place at some point in future.
Value investors may suffer in the short run from avoiding overvalued stocks in favor of undervalued stocks, cash or bonds. However, over the long run, a willingness to go against other investors in a bull market can pay off through being able to access lower stock prices in an eventual bear market. As Marks once said, "Nothing goes in one direction forever".
A cautious approach
Evidence of increasing investor optimism can be seen in the Volatility Index, or VIX. It measures investor sentiment and is often known as Wall Street's "fear gauge." It increased in value from around 25 prior to the February/March decline in stock prices to reach a high of 82 by mid-March. This highlighted how fearful investors had become about the economic outlook, since a higher figure suggests greater concern.
Today, it has fallen back to around 25. This suggests that investor sentiment is relatively strong, and there is apparently little concern for the uncertain economic outlook even though the real situation has not improved. Therefore, in my opinion, adopting a cautious mindset when allocating capital could be a prudent strategy at the moment. Investors may not be fully taking into account the uncertain outlook for many businesses, which perhaps should be reflected in their valuations.
As Marks once said, "We must strive to understand the implications of what's going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious. When others are frightened into action or panic selling, we should become aggressive."
Preparing for a bear market
A bear market may be very likely to take place at some point in future. However, predicting when it will occur is impossible, in my opinion, because there are a wide range of variables that can impact on stock prices.
Therefore, preparing for a stock market decline may be a more efficient use of your time than trying to forecast when it will take place. For instance, ensuring that current portfolio positions are not trading significantly above their intrinsic values may lead to an avoidance of overvalued stocks that are hit hardest in a market fall.
In addition, identifying potential buying opportunities ahead of time may allow you to move quickly should there be a short, sharp bear market similar to that experienced in March.
Marks has always sought to ready himself for a change in market conditions. As he previously said, "You can't predict. You can prepare."
Read more here:
- Warren Buffett: Don't Waste Time Trying to Predict the Future
- Charlie Munger on Preparing for the Next Bear Market
- Seth Klarman: Value Investing Can Pay Off in the Long Run
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