A timely set of rules comes from a former Wall Street strategist, Bob Farrell, who pioneered the technical analysis of stock movements. Farrell also broke new ground using investor sentiment figures to better understand how markets and individual stocks might move.
Nowadays, with global markets gyrating, Farrell’s rules offer investors some perspective:
1. Markets tend to return to the mean over time
By “return to the mean,” Farrell reminds investors that when stocks go too far in one direction, they tend to come back to their long-term trend. Overly euphoric or pessimistic markets cloud people’s estimation and judgment of what they can reasonably expect.
2. Excesses in one direction will lead to an opposite excess in the other direction
Markets in a bubble can seem ready to pop, yet they manage to stretch into unrecognizable shapes — and still find buyers. Think of Internet shares a decade ago or real estate before the housing crash. When the bubble bursts, watch out.
3. There are no new eras — excesses are never permanent
This relates to rules No. 1 and No. 2. Many investors latch on to the latest hot sector, and soon a fever builds that “this time it’s different.” It never is, of course. When the sector cools, individual shareholders are usually the last to know and sell at lower prices.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
This is Farrell’s way of saying that a popular sector can stay hot for a long while, but will fall hard when a correction inevitably occurs.
5. The public buys the most at the top and the least at the bottom
The time to buy stocks is when others are fearful and sell when others are complacent. Accordingly, many market technicians use sentiment indicators to gauge investor pessimism or optimism, then recommend that investors do the opposite.
6. Fear and greed are stronger than long-term resolve
Investors can be their own worst enemy, particularly when emotions take hold.
To counter fear and greed, practice self-control. In down markets, keep enough cash on hand so you’re not tempted to sell at fire-sale prices and instead can buy on the cheap. In headier times, prune winners to the range you set for your portfolio’s asset allocation and use the proceeds to buy laggards. This strategy will help you to be proactive instead of reactive.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
There’s strength in numbers, and broad, powerful market momentum is hard to stop, Farrell observes. Conversely, when money channels into a shallow stream, many attractive companies are overlooked as investors crowd one side of the boat.
8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
9. When all the experts and forecasts agree — something else is going to happen
Going against the herd as Farrell repeatedly suggests can be quite profitable, especially for patient buyers who can raise cash in frothy markets and reinvest it when sentiment is darkest.
10. Bull markets are more fun than bear markets
Now that is reassuring enough.