Merrill Lynch’s legendary market strategist, Bob Farrell, penned the following market maxims worth a quick review (h/t The Big Picture):
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1. MarÂkets tend to return to the mean over timeWhat would you add to this list?
When stocks go too far in one direcÂtion, they come back. EuphoÂria and pesÂsimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.
2. Excesses in one direcÂtion will lead to an excess in the oppoÂsite direcÂtion
Think of the marÂket baseÂline as attached to a rubÂber string. Any action too far in one direcÂtion not only brings you back to the baseÂline, but leads to an overÂshoot in the oppoÂsite direction.
3. There are no new eras – excesses are never perÂmaÂnent
WhatÂever the latÂest hot secÂtor is, it evenÂtuÂally overÂheats, mean reverts, and then overshoots.
As the fever builds, a choÂrus of “this time it’s difÂferÂent” will be heard, even if those exact words are never used. And of course, it – human nature – is never different.
4. ExpoÂnenÂtial rapidly risÂing or falling marÂkets usuÂally go furÂther than you think, but they do not corÂrect by going sideÂways
RegardÂless of how hot a secÂtor is, don’t expect a plateau to work off the excesses. ProfÂits are locked in by sellÂing, and that invariÂably leads to a sigÂnifÂiÂcant corÂrecÂtion eventually.
5. The pubÂlic buys the most at the top and the least at the botÂtom
That’s why contrarian-minded investors can make good money if they folÂlow the senÂtiÂment indiÂcaÂtors and have good timÂing. Watch Investors IntelÂliÂgence (meaÂsurÂing the mood of more than 100 investÂment newsletÂter writÂers) and the AmerÂiÂcan AssoÂciÂaÂtion of IndiÂvidÂual Investors Survey.
6. Fear and greed are stronger than long-term resolve
Investors can be their own worst enemy, parÂticÂuÂlarly when emoÂtions take hold. Gains “make us exuÂberÂant; they enhance well-being and proÂmote optiÂmism”, says Santa Clara UniÂverÂsity finance proÂfesÂsor Meir StatÂman. His studÂies of investor behavÂior show that “losses bring sadÂness, disÂgust, fear, regret. Fear increases the sense of risk and some react by shunÂning stocks.”
7. MarÂkets are strongest when they are broad and weakÂest when they narÂrow to a handÂful of blue-chip names
This is why breadth and volÂume are so imporÂtant. Think of it as strength in numÂbers. Broad momenÂtum is hard to stop, FarÂrell observes. Watch for when momenÂtum chanÂnels into a small numÂber of stocks.
8. Bear marÂkets have three stages – sharp down, reflexÂive rebound and a drawn-out funÂdaÂmenÂtal downtrend
9. When all the experts and foreÂcasts agree – someÂthing else is going to hapÂpen
As Sam StoÂvall, the S&P investÂment strateÂgist, puts it: “If everybody’s optiÂmistic, who is left to buy? If everybody’s pesÂsimistic, who’s left to sell?”
Going against the herd as FarÂrell repeatÂedly sugÂgests can be very profÂitable, espeÂcially for patient buyÂers who raise cash from frothy marÂkets and reinÂvest it when senÂtiÂment is darkest.
10. Bull marÂkets are more fun than bear marÂkets
EspeÂcially if you are long only or manÂdated to be fully invested. Those with more flexÂiÂble charÂters might squeak out a smile or two here and there.
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