Equity markets have really surprised to the upside over the past couple of months. During the first half of the year, the S&P 500 fell around 20% as investors started to fret about the direction of the U.S. economy and inflation jumped to a multi-decade high.
At the same time, we had the bursting of the SPAC and tech bubbles as investors re-evaluated growth prospects for these companies. All of these factors hit equity markets and investor sentiment incredibly hard.
However, sentiment has dramatically improved over the past two months, and the equity market has rallied. Analysts are becoming increasingly concerned that this rally is getting ahead of itself. And there are historical precedents for bear market rallies occurring in the middle of a significant drawdown.
Investor sentiment has improved quickly, but the outlook for the economy has hardly improved. In fact, one could argue that the economy’s outlook is worse now than it was a couple of months ago.
The irrational market
Ive seen plenty of analysts try to guess what could be driving the current market rally.
One possible explanation is that share repurchases are driving equities higher at a time when general trading volumes are extraordinarily depressed. As such, repurchases are having a disproportionate impact on the market.
Another factor to consider is that equity markets tend to be forward-thinking indicators. The market was pricing in a possible economic contraction months before one emerged. Now we know the potential scale of the economic downturn, investors could be buying back into the market on the belief that it will not be as bad as initially expected.
These are some potential explanations, but the fact is that its just impossible to tell. Every analyst has their own explanation, and only a handful of them are likely to be correct.
The market is a complex organism with millions of different participants. Each one of these participants has a different reason for buying or selling securities. It is impossible to tell what they think. The market is the only broad-based indicator of investor sentiment. If the market is heading higher, that seems to suggest that market participants on average have a positive outlook on the near-term future of equities.
Trying to second-guess the market is generally a waste of time. Market timing is almost impossible for long-term investors. However, short-term traders might have a better time of it (I am not advocating short-term trading over long-term investing, but I do believe that short-term traders have more of a feel for market movements over periods of days and weeks rather than years).
Sit on your hands and invest in the best
With the above being the case, the rather dull answer that I have come up with to the question of what investors should do in the current market is twofold: 1) do nothing, and 2) invest in the best.
Market timing has historically proven to be a bad idea for long-term investors, so overall it is better to just stick to fundamentals and not take on a more active trading strategy just because equities are down.
The companies that will fare best in a challenging economic climate are those that will fare best in any economic climate. Im talking about the sector champions, the global leaders in their particular fields. Companies like Microsoft (NASDAQ:MSFT), one of the worlds largest cloud computing and office software providers, are a great example of this in my opinion.
Even if the global economy goes into a recession over the next couple of years, it seems likely the demand for Microsoft’s products will only increase. The company also has a huge amount of pricing power, meaning it can increase prices in line with inflation to protect its profit margins and bottom line.
Theres no point trying to time the market with these kinds of companies because they will always command a premium over other businesses. Companies with a solid competitive advantage and larger-than-average profit margins will almost never be cheap without good reason.
I also belive that in times of uncertainty, its best to stick with what we know. It might be tempting to get outside our circle of competence in changing market situations, but that brings the risk of making mistakes.
This article first appeared on GuruFocus.
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