The greater fool theory is where investors buy stocks with the aim of selling them to a "greater fool" who is willing to pay more for them at a later date. Therefore, the theory does not necessarily require an investor to purchase undervalued stocks or consider a company’s fundamentals. Rather, they just need investor sentiment to improve during their holding period so they can sell stocks at a profit.
The theory may be relevant today because of the ongoing bull market. Investor sentiment is extremely strong, with many stocks trading at valuations that are significantly higher than their long-term averages. They are largely being justified by upbeat earnings forecasts that may not fully factor in the risks facing the economy.
For example, there is an ongoing threat of lockdowns in many major economies, particularly in Europe. Other risks include rising inflation and supply-side challenges that could hurt the world economy’s growth rate. These and other threats could derail the prospects for investors and compromise the greater fool theory’s recent success in a stock market that has doubled since March 2020.
Marks’ view
Oaktree Capital co-founder Howard Marks (Trades, Portfolio) has previously discussed the limitations of the greater fool theory. He once said, “Unfortunately, the greater fool theory only works until it doesn’t. Valuation eventually comes into play, and those who are holding the bag when it does have to face the music.”
Marks’ opinion is particularly relevant at the present time. Ultimately, history suggests that some event is likely to take place that causes investor sentiment to weaken and the current bull market to end. It may be a threat that is currently known about, but could equally be a catalyst that comes without prior warning.
Therefore, it may be prudent to ensure that any new or existing holdings continue to offer a margin of safety. Stocks that trade at or above their intrinsic values may be hardest hit in any future downturn or bear market. Avoiding or selling such stocks could be a prudent long-term move.
A long-term strategy
Of course, today’s overvalued shares may continue to post strong gains in the short run. Catalysts such as a dovish Federal Reserve and vast amounts of fiscal stimulus may push asset prices to even higher levels.
As such, the greater fool theory could persist for many months or even years. This could cause a significant amount of frustration for investors who sell shares to hold cash on valuation grounds – especially when other investors continue to profit from the "foolishness" of their peers.
However, as Marks states, valuations eventually return to being relevant to investors. Those individuals who avoid today’s excessively high valuations could find themselves well-placed to capitalize on unjustifiably low share prices in the next bear market.
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