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Enjoying the boom? Not so fast…

Rising share prices have been making for happy investors over the past 12 months or so. And why wouldn’t they? We’re still well off the all-time high of 6,828 on the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO), but the index is at its highest point in almost 5 years.

Share prices are up 10.5% on that same index since the beginning of 2013 and 21% over the past 12 months. Including dividends, index investors are up 26.7% over the past year, and 12% so far this year. Indeed, including dividends, the ASX 200 is only 2.5% below its all-time high, set in November 2007. Breathing a sigh of relief, investors have almost shaken off the pain of 2008 and 2009, and particularly with interest rates falling are committing more and more money to shares.

Higher prices aren’t the investor’s friend

That approach is understandable – for long-term investors, the last few years have been tough. With our collective heads now above water, all finally seems right with the world.

If you’re in retirement, and living off the proceeds of slowly selling down your investment portfolio, the market is exactly where you’d want it. However, for the rest of us, higher prices are nothing to cheer. Yes, you read that right – and here’s why.

In last year’s letter to Berkshire Hathaway (NYSE: BRK-A, BRK-B) shareholders, Warren Buffett addressed exactly this problem. He wrote:

“The logic is simple: If you are going to be a net buyer of stocks in the future… you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.”

The petrol price is a great analogy, as are power prices. Who among us (other than those with an energy-dominated share portfolio, perhaps) rejoice when power prices rise? Of course, we all want higher share prices in the years and decades ahead, but we should be wishing for that process to be slow in happening, so we can save and invest at lower rates today.

Feeling better? Don’t relax just yet

Unfortunately, most investors are more impacted by the ‘wealth effect’ and the comfort of a rising tide than the reality that the higher share prices go, the harder bargains will be to find. Remember, the last time we had investing euphoria was in 2007 – and we’re yet to regain those heady levels.

To invest well, we need to take a contrarian mindset. We need to, in Buffett’s words, “be greedy when others are fearful and fearful when others are greedy”. Simply applying that approach would have seen investors buying only cautiously in 2007, and then much more eagerly in 2008 and 2009 – or at the very least, resisting the fear-induced temptation to sell when markets slumped.

According to S&P Capital IQ, the S&P/ASX 200 is trading on the highest level – as measured by the trailing price/earnings ratio – in over two years. So much so, that the average P/E has increased by around 50% since this time last year!

Be careful of inflated expectations

Remember, prices only increase for two reasons – either profits grow, or investors are prepared to pay more for each dollar of profit. I’m not suggesting we’re in any sort of bubble at the moment, but we’d be well advised to buy carefully from this point on.

Specifically, our banks are selling at very high multiples – especially considering the low growth that they are delivering. Today’s dividend looks good, but they can only grow those dividends if profits grow. Ditto share prices.

Equally, be careful of mining companies when prices are at the mercy of global supply and demand. The gold price is at the mercy of the collective mood of the market – with no intrinsic value to underpin it. Yes, there are complex theories explaining how the price should move, but even if those theories are correct, no one can reliably measure whether the current price is right in the first place. For example, the theory suggests that gold should be more expensive when inflation is higher, and cheaper when inflation is lower. If we accept that, the question is ‘objectively higher or lower than what level of fair value?’

Meanwhile, the iron ore price could be significantly lower for a long period of time, if commentary from BHP Billiton proves to be correct, in the face of a potential supply glut. When supply grows more slowly than demand, prices have little choice but to fall.

Foolish takeaway

Investing is an inherently uncertain pursuit. The investor’s job is not to eliminate uncertainty, but to put the odds in our favour. You do that by looking for great businesses, and paying an attractive price, which allows for the degree of uncertainty and risk.

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