History never perfectly repeats itself. However, it can provide a useful guide for investors seeking to understand how the stock market may perform in the future.
For example, the stock market has been cyclical throughout its history. Bull markets and bear markets have followed one another, with neither lasting in perpetuity. In fact, there have been 14 bear markets and 15 bull markets over the past 75 years.
Periodically, some investors overlook the existence of the stock market cycle. For instance, they may become overly pessimistic about the prospect of a recovery during the depths of a bear market. This may lead them to avoid purchasing high-quality companies at low prices. Conversely, they may become overly confident during a bull market and purchase overpriced stocks based on a belief that a rising stock market will continue unabated.
Learning from history
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) chairman Warren Buffett (Trades, Portfolio) has previously commented on the apparent inability of some investors to use history as a guide to the future. As he once said, “What we learn from history is that people don't learn from history.”
In my opinion, Buffett’s view could be extremely useful for investors seeking to apportion capital in today’s stock market environment. The Volatility Index (VIX), which measures investor sentiment, currently stands at a level of around 15. This is slightly lower than shortly before the March 2020 crash occurred and suggests that investor sentiment is extremely strong at the present time.
However, investors may be overlooking threats such as rising inflation, an increasingly hawkish Federal Reserve, ongoing threats from Covid-19 and rich valuations among some stocks. Clearly, these factors do not necessitate a market decline or bear market in the near term. But investor sentiment currently suggests that some market participants may view this bull run as being "different" than previous bull markets and that it will last in perpetuity. History, though, suggests otherwise.
Today’s application
Clearly, it is impossible to predict when the next bear market will occur. However, it is possible to gradually prepare for it through a simple strategy.
For example, it may be prudent to avoid companies that trade at, or above, their intrinsic values. Certainly, their share prices could move higher in the short run due to buoyant investor sentiment, but such companies may be among the worst hit when the stock market’s recent upward progress is interrupted.
Similarly, holding stocks that have sound fundamentals, such as low debt levels and a solid track record of financial performance, may be a logical strategy. They could overcome economic challenges more easily than their weaker peers. Meanwhile, investors who allow their portfolio’s cash balance to gradually increase, rather than being fully invested, may be better placed to capitalize on lower valuations in the future.
These strategies may mean missing out on further stock market growth in the short run if the current bull market continues. However, they may provide superior long-term returns as history repeats itself, albeit imperfectly.
