It's easy to forget about the market cycle during a bull market. Rising valuations, increasing investor optimism and upbeat earnings forecasts can make it tempting to believe that stock prices will rise forever.
However, the past performance of the stock market shows that this viewpoint has never yet played out. Every previous bull market has been superseded by a bear market. In the past 75 years, there have been 14 bear markets. In future, there are likely to be many more.
In my opinion, it is arguably more important than ever to seek a margin of safety today after the stock market's two-thirds rise since March 2020.
The market cycle has not disappeared
The stock market has continually experienced a cycle where it has moved from bull market to bear market, and back, during its history. A key reason for this is investor overexuberance during periods of economic growth and heightened fear during uncertain times. They have often caused stock prices to move to excessively high and low levels for temporary periods.
This situation has previously been summarized by Oaktree Capital cofounder Howard Marks (Trades, Portfolio):
"At one extreme of the pendulum – the darkest of times – it takes analytical ability, objectivity, resolve, even imagination, to think things will ever get better. The few people who possess those qualities can make unusual profits with low risk. But at the other extreme, when everyone assumes and prices in the impossible – improvement forever – the stage is set for painful losses. It all goes together. None of these is an isolated event or a chance occurrence. Rather, they're all elements in a recurring pattern that can be understood and profited from."
When will the next bear market occur?
The stock market has previously experienced a bear market every four years on average. However, the time between them has ranged from a number of weeks to 13 years. Therefore, they can occur at any time. This means that a bear market is no less likely just because the current bull market is under a year old.
At the moment, investor optimism is extremely high. This is evidenced by the VIX index being at a similar level to before the 2020 market crash despite political and economic risks being high. Likewise, the rich valuations of many large-cap stocks may not take into account the potential for anything less than a 'best case' scenario.
This does not necessarily mean that a bear market is imminent. Bubbles can grow should investor sentiment continue to improve. However, it does mean that opportunities to make high capital returns could be much more limited than they were in recent months due to many companies trading in excess of their intrinsic values.
The market cycle provides opportunities
In my opinion, a prudent strategy to navigate the market cycle is a focus on obtaining a margin of safety on stock purchases. This helps to protect a portfolio from an inevitable bear market that could hurt the prices of overvalued shares to a greater extent than undervalued stocks. It may also allow an investor to capitalize on cheap share prices that produce high returns in the long run.
Even though bear markets are feared by some market participants, they could provide buying opportunities for long-term value investors. They cause many quality firms to trade at temporarily low prices that include wide margins of safety.
Just as bear markets follow bull markets, the reverse is also true. Therefore, waiting for bear markets to occur before buying stocks could be a means of allocating capital efficiently and taking advantage of the perpetual market cycle.
Read more here:
- Warren Buffett: Use Fundamentals, Not Formulas, When Investing
- Seth Klarman: A Margin of Safety Is Crucial in Bull Markets
- Warren Buffett: Don't Cheer When the Stock Market Soars
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