As the stock market has gone from strength to strength over the past few weeks, investors and analysts have understandably started to question whether or not the market rally has gone too far.
The valuations of some equities now appear to be significantly disconnected from the underlying economic environment and even from their fundamentals.
Unfortunately, trying to predict whether an asset or market is overvalued is one of those things in investing that's just impossible to answer correctly.
The only way one would be able to provide a correct answer to this question is if one could see the future. The process of business valuation is highly subjective. Just because one business looks overvalued on a particular valuation metric, it does not mean that the stock will not produce high returns in the years ahead.
Learning from the past
This time last year, the true scale of the coronavirus pandemic was only really becoming apparent. Stock markets around the world were plunging, and the Federal Reserve was getting ready to unleash a bazooka of cash to try and calm markets.
Amid the carnage, I looked to Howard Marks (Trades, Portfolio) to provide some guidance in uncertain times. In particular, in an article at the beginning of March 2020, I highlighted a section from one of Marks' 2008 letters:
"I'd recommend that clients begin to explore possible areas for investment, identify competent managers, and take modest action. But still cautiously, and committing a fraction of their reserves..."
A month later, the value investor released a memo reiterating this advice and telling readers that the best time to buy a stock is when it looks good value, and not worry about trying to time the market:
"So it's my view that waiting for the bottom is folly. What, then, should be the investor's criteria? The answer's simple: if something's cheap – based on the relationship between price and intrinsic value – you should buy, and if it cheapens further, you should buy more."
This was Marks' advice in two market drawdowns. This week, he issued another memo commenting on the current market environment.
The risks we face today
The value investor outlined the key risks the market faces today. He also outlined the opportunities, primarily the potential for a better-than-expected economic recovery, which would support high equity valuations.
On balance, the risks, challenges and opportunities suggest "the prices of most assets are in a gray area," the memo noted. Overall, they are not too high considering the interest rate environment, but they're also not too low.
These observations produced the following conclusion:
"This past year challenged many preconceived notions about the economy, markets and policy – and even changed the way we live. But the inescapable truth of investing remains unchanged: there is no magic answer, no solution (other than superior skill) that will enable an investor to earn a high return safely and dependably. And that's especially true in today's low-return world."
To put it another way, the environment today is very similar to the market of March 2020.
Uncertainty prevails, we don't know what the future holds and trying to predict the outlook for stocks is a fool's game. It seems unlikely equities will continue to produce double-digit returns in the years ahead, but it's not impossible. The equity market could be overvalued or undervalued depending on what the future holds for the economy.
With this uncertainty, the best playbook for investors in the current market is to follow Marks' advice from the crashes of 2008 and 2020. There's no point trying to wait for the top or the bottom. If something looks cheap, it makes sense to buy it. If it seems expensive, it might be a good idea to avoid it.
Read more here:
- What We Can Learn From Bill Ackman's Outstanding Comeback
- Where the World's Most Profitable Hedge Fund Is Investing
- Value Hedge Funds Tend to Have More Concentrated Portfolios Than Growth Funds
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
