The S&P 500 is up nearly 15% this year. That rise represents the weighted average of 500 top companies, meaning it only tells part of a larger picture. Some individual stocks are carrying more than their own weight in the story, and while some of their gains make sense, some prices are on their way to becoming inflated and unsustainable.
Warren Buffett has spoken out on this very topic, and he has a strong opinion about it.
The dangers of a bull market
Don't investors love bull markets? Of course. That's when you see the value of owning stocks. Even when the market does go into bear territory, top stocks don't lose nearly as much as they gain in good times overall.
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But that doesn't mean bull markets are a free-for-all. Newer investors in the previous bull market thought investing was a cinch as they watched prices balloon seemingly to limitless levels. In the wake of last year's steep losses, they've been rudely awakened from that fallacy. But those who have a long enough time horizon are hopefully learning how to invest effectively instead of panic-selling and running for the hills. Many of the stocks that lost value will make it up over time, and some have already rebounded to new highs.
The problems start when investors bid up stock prices in their excitement and lose focus on whether or not a stock's price is tied to its fundamental value. When a stock trades at 200 times trailing-12-month earnings and continues to rise, investors should be very wary.
That's where Warren Buffett's famous adage comes in.
Greedy or fearful?
One of Buffett's most famous quotes comes from Berkshire Hathaway's 1986 shareholder's letter. "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
He continued:
What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves? Unfortunately, however, stocks can't outperform businesses indefinitely.
Buffett is known for his value-oriented approach to investing. That involves finding exceptional opportunities in the market where prices look like they are below the intrinsic value of the company, whether its assets, growth potential, or other measurable markers. This strategy predicts that the price will eventually rise to meet the company's real value.
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Often in bull markets, investors, especially inexperienced ones chasing growth stocks, tend to do the exact opposite of this. They see which stocks are going up, assume those must be great stocks worth buying, and buy at the height of an ascent.
The value approach works here the opposite way: The price will eventually drop to meet the company's real value.
A sobering account
Perhaps the poster child of this wild investing strategy is artificial intelligence lending company Upstart Holdings. Upstart was reporting incredible growth in the low-interest-rate, easy-money environment that characterized the pandemic-stimulus climate. It delivered triple-digit sales growth, and it was profitable. The stock price skyrocketed, and its price-to-sales ratio nearly climbed to 50 before the stock crashed.
Upstart seemed like a great business, but it was untested in high-interest-rate environments. It was also young and made a few missteps. Upstart stock is still down 90% from its all-time high, and it's posting sales declines and net losses.
Despite the grim near-term outlook, Upstart stock is already up over 200% in 2023. Its trading at a price-to-sales ratio of 5.4 as of this writing -- this already looks too high, and investors are in danger of making the same mistake again.
Be like Buffett
Buffett often goes on buying sprees when the market's down, but he also typically finds bargains in any kind of market, and so can you. As you see prices going up, your initial instinct might be to jump in and run with the bulls. Resist that urge, and take the time to make sure the price you're paying for any given stock isn't getting away from its fundamentals.
