Investors love a good market rally for obvious reasons, but could that end up being too much of a good thing?
In the stock market, yes. If investors get ahead of themselves, or ahead of real economic conditions and business fundamentals, by sending the market up too much too fast, it's likely to come tumbling back down. That often becomes a stock market correction, which is exactly what it sounds like. When the value of the market becomes completely out of touch with reality, it could go down even more, morphing into a bear market.
That was the state of the market last year. Valuations had become incredibly inflated with many of them becoming completely out of touch from the real underlying value of many companies, especially unprofitable ones. When economic conditions took a turn for the worse, stocks couldn't carry those valuations, and the market dropped as a result.
Getting back to the current rally, which is close to bringing the S&P 500 to a fresh all-time high, is it safe to invest now?
Why the market's rallying
Cooling inflation and the promise of a technological sea change with the explosion of generative AI have been the major themes behind rising stock prices this year.
Other recent developments have also been encouraging, including the latest earnings season. Amazon, a bellwether for the retail industry, reported a 13% year-over-year increase in sales for the third quarter as net income more than tripled.
The consumer price index stayed constant in October too, which means prices didn't rise from the year-ago period. Retail sales declined slightly in October from a month earlier, the first decline since March. As the economy holds steady with inflation down, the likelihood of a recession and the Federal Reserve raising interest rates further decreases. There are indications the Fed could lower interest rates in the coming months, leading to greater investor confidence.
How to leverage the rally without getting into the danger zone
The S&P 500's 19% gain year to date puts it on the cusp of a fresh bull market. Many investors are being lured back into stocks in this environment, but much of the recovery has already happened. Since the best time to buy is before prices rise, is it too late?
One way to evaluate whether or not a stock is still a good deal is to make valuation a critical part of your investment analysis. A company with a massive opportunity and strong track record might look like a great buy. But if the share price is already attached to a valuation that rides on investors' high expectations for growth, you might want to take a pass. That said, it's important to understand valuation as something contextual because a high-growth company will naturally deserve a premium over a low-growth one.
Even if the bull market is already here, you can still find undervalued or fairly-priced stocks. Getting back to Amazon as an example, share are up almost 60% in the past year, but its price-to-earnings ratio has actually declined over the same period. That puts the stock's rally in a much different light.
Data by YCharts.
You can find great stocks in any market
Being in the market is ultimately more important than the exact timing of when you buy your stocks. Remember the S&P 500 has been a consistent winner for long-term investors. That said, you can further improve your returns and manage your risk exposure by focusing on the right factors with individual stocks too. Whether or not a bull market is here, keep things like valuation in mind and avoid investor hype.
