The stock market’s 23% decline since the start of the year could prompt some investors to avoid buying shares. Indeed, in some cases they may even seek to sell their holdings to avoid further losses over the short run as geopolitical and economic risks remain high.
This represents a drastic change in sentiment from the start of the year. Many investors were bullish about the prospects for the stock market and were even seeking to purchase companies when they traded on significantly higher valuations than today.
This is evidenced in the Volatility Index (VIX), which measures investor sentiment. A higher reading suggests greater fear among investors. It has increased by 90% since the start of the year, which indicates that investors are far more cautious now than they were several months ago.
An illogical mindset
In my opinion, this trend of buying high and selling low is an illogical way to manage a portfolio. All investors seek to profit from their holdings, and the most obvious way of doing that is to buy at a low price and sell at a higher price.
In hindsight, investors should have been far more cautious than they were at the start of the year, when share prices were at incredibly high valuations, and should now be looking for value opportunities due to the low prices and valuations that are on offer. This strategy is more likely to lead to profits in the long-run, especially if you can find good companies trading at bargain prices.
This viewpoint has previously been highlighted by Baupost founder Seth Klarman (Trades, Portfolio). As he once said, “In my opinion, the market tells you when to buy things. And when things are really cheap, on a Graham and Dodd valuation basis, you should like them more. And when they’re really expensive, you should like them less.”
Cutting through short-term movements
Of course, cheap shares can become even cheaper. The current bear market may persist for weeks, months or even years, and in doing so could produce further paper losses for investors. However, history shows that the overall stock market is very likely to make a full recovery in the coming years. Investors who use the market cycle to their advantage, in terms of buying low and selling high, have a higher chance to generate above-average returns.
In my view, the key aspect of investing during a bear market is ensuring your holdings can survive short-term difficulties to prosper in the long run. At the moment, assessing company debt levels is extremely important, more so than it has been for over a decade, as interest rates rise to levels last seen prior to global financial crisis. It's also important to identify companies that have a wide economic moat which allows them to capitalize on growth opportunities as the economy recovers.
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