During a bull market, it can feel as though share prices will rise in perpetuity. History, though, shows that they do not. In fact, a bear market has historically followed a bull market just as night follows day. The problem, though, is ascertaining when this will happen.
Herd mentality
Of course, one of the difficulties in trying to call the top of the stock market is the behaviour of other investors. During a bull market, various commentators and investors inevitably become overconfident in the returns they have made. They will believe that such returns are not only possible, but are to be expected in the long run. Going against such a feeling can be difficult, since it means potentially missing out on short-term gains which may be on offer as a bull market continues.
However, an investor who is able to focus on facts and figures, rather than listening to his/her peers, can take a major step towards being able to call the top of the stock market.
Valuations
One method of deciding when share prices are too high is to focus on valuations. While the value of any company is subjective, it is possible to gauge whether it is historically high or low. Take, for example, the S&P 500 at the present time. It has enjoyed almost a decade of significant gains and has been able to reach record highs along the way. It currently has a price-to-earnings (P/E) ratio of around 23. While its P/E ratio has been higher in its 90-year history, those occasions can be counted on one hand and have never lasted for an extended period of time.
Certainly, the S&P 500 could move higher. However, the reality is that there is unlikely to be another nine year Bull Run ahead. This means that investors may now wish to reduce their exposure to companies and sectors that appear to be the most overvalued on a relative basis.
Closed for business
Clearly, trying to time the market is intensely challenging. It is difficult to decide how significant particular risks could become over the medium term. However, one method of deciding whether a stock, industry or even stock market is worth buying for the long term is to imagine that once purchased, no sales can be made for five years. This should ensure that an investor focuses not only on the potential for further gains in the continuation of a bull market, but also considers the risk of a potential bear market within the next five years.
Takeaway
While accurately predicting the top of the stock market may require a degree of luck, focusing on valuations can provide guidance on whether buying or selling is the best move for an investor to make. And by focusing on the long term as well as ignoring the views of the investment ‘herd’, it can be possible to take advantage of the peaks and troughs of share prices.