How to Invest in a Sizzling Market

 | Jun 03, 2014 | 1:00 PM EDT
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The title of this column is somewhat misleading -- although it makes a point. If I try to provide specific guidance on how to invest in a sizzling or frothy market, then by default I am admitting that there are two different ways to invest. In fact, in my view, there is only one way to invest, and that entails buying securities at a meaningful discount to intrinsic value.

Whether that discount is found in the depths of a bear market or the heights of a bull market is generally irrelevant. If Chipotle (CMG) shares were trading for $250 today, would it really make a difference whether the S&P 500 was at 1,900 or 1,600?

So the general answer to the title of this column is that the true fundamental principles of investing don't deviate because of the market level. In fact, if the ultimate objective is buying undervalued securities, the market environment should dictate the abundance or lack of eligible opportunities. That is how you invest in frothy markets: If there is nothing to buy, then buy nothing. The mere act of not buying is an investing decision.

However, there is an additional consideration during optimistic markets. Because rising markets open the door for significant corrections or declines, cheap things can get cheaper. In the words of John Maynard Keynes, the market can stay irrational longer than one can stay solvent.

General Motors (GM) is a great example of this. At $35 per share, the company is trading at what is viewed by many (including me) as a very attractive valuation for the patient investor. Yet if the market were to have a strong correction, it's likely that GM shares (and many other securities) will correct as well. A cheap security would get even cheaper. For the opportunistic investor, that would be a welcome event. But let's be honest: For the majority of individual investors, watching a stock decline by 30%, 40% or even 50% is too much to handle, and the immediate reaction is to get out.

That's the curse of the bull market -- just as a rising tide lifts all boats, a crashing wave takes a lot of things down with it. So investing in climbing markets does add the additional element of a general market decline affecting anything and everything.

Investing demands an exceptional degree of caution. More important, one's standards of valuation should not be swayed just because the market is going up. In bull markets, everyone looks like a stock market genius. But longevity in the investment arena is not defined by only bull markets but the entire market cycle.

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