How can an investor make useful observations regarding the status of the markets? Most of the time, markets are near the middle ground — perhaps a little high or a little low, but not so extreme as to permit dependable conclusions.
Investors’ records of success with calls in markets such as these are poor. Even if they are right about asset prices being out of line with fundamental valuations, it is very easy for something that is a little overpriced to go on to become demonstrably more so, and then to turn into a raging bubble, and vice versa.
However, once in a while, markets go so high or so low that the argument for action is compelling and the probability of being right is high. When markets are at these extremes, the key to generating superior future investment returns lies in understanding what is responsible for the current conditions.