The stock market has always experienced booms and busts. Indeed, there have been 27 bull markets and 26 bear markets since 1928. This is due to the existence of the market cycle, which means neither period ever lasts in perpetuity.
Of course, it can be easy to forget about the market cycle in the midst of the current bull run. Investors have enjoyed an 80%+ rise for the S&P 500 in the past 14 months. Further growth may be ahead. However, the stock market's performance is very unlikely to remain uninterrupted over the long run.
That's despite the huge scale of monetary and fiscal stimulus that has been announced in recent months. Even though major stimulus provides fertile ground for economic growth and stock market gains, it does not mean that the market cycle has become extinct. Eventually, a reversal is almost inevitable.
This point has previously been highlighted by Oaktree Capital cofounder Howard Marks (Trades, Portfolio). As he once said:
"The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum "on average," it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward an extreme itself that supplies the energy for the swing back."
An extended bull market?
I think Marks' comments are highly relevant in today's stock market environment. Investors have become extremely optimistic about the prospects for many companies. They may not be factoring in the risks they face over the long run. The more upbeat investors become and the longer the current bull market lasts, the greater the potential for a sharp market decline.
Clearly, determining when that fall will take place is impossible. A huge number of variables can combine to affect stock prices, including interest rates, geopolitical factors and the pandemic's future course. They are extremely unpredictable. Indeed, it could take anything from days to years for the stock market "pendulum" to swing back to a lower price level. Marks has previously discussed this viewpoint. As he once said:
"Prices are too high is far from synonymous with the next move will be downward. Things can be overpriced and stay that way for a long time or become far more so."
A patient approach to investing
In my view, a patient approach is required when investing in stocks. It can take time for overvaluations to be corrected and for more attractive buying opportunities that offer wider margins of safety to present themselves. Indeed, the longest bull market lasted for around 13 years from 1987 to 2000. Of course, its aftermath was the bursting of the tech bubble that wiped 45% from the S&P 500's price level over a period of around two years.
As such, building a cash pile instead of buying richly valued stocks could be a prudent approach in today's bull market. It may limit potential losses in the next stock market crash by avoiding shares that currently lack a margin of safety. In addition, it may provide the liquidity needed to quickly respond to the next stock market decline when Marks' so-called stock market "pendulum" eventually begins its reversion to the mean.
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