Jim Kopas

One of the market strategists that I like to follow is Bob Farrell, the former Chief Stock Market Analyst at Merrill Lynch & Co. Below I have summarized Mr. Farrell’s famous “10 Market Rules to Remember,” courtesy of MarketWatch (June 2008). These words of stock market wisdom are timeless and are important to keep in mind during any stock market environment but are especially valuable to remember today.

1. Markets tend to return to the mean over time

When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective. Recent Example: Housing Market drops after excessive growth.

2. Excesses in one direction will lead to an opposite excess in the other direction

Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction. Recent Example: Bank lending is now tight after years of lenient bank lending. 

3. There are no new eras — excesses are never permanent

Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots. As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it — Human Nature — never is different. Recent Example: Look at how far the emerging markets and BRIC nations ran over the past decade, only to get cut in half.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways

Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Markets correct by moving in the opposite direction, dropping sharply after the market becomes overbought and rallying after prolonged market weakness. Recent Example: Take a look at the S&P 500 over the last two years.

5. The public buys the most at the top and the least at the bottom

That’s why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing. Recent Example: In 1999 and 2000 massive amounts of capital flowed into technology-focused mutual funds (at the stock market peak) and in 2002 and 2003 (at the stock market base) outflows from mutual funds were at their highest level.

6. Fear and greed are stronger than long-term resolve

Investors can be their own worst enemy, particularly when emotions take hold. Gains “make us exuberant; they enhance well-being and promote optimism,” says Santa Clara University finance professor  Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.” Recent Example: Look at your own investment history.  How did your emotions towards the stock market change throughout the “good years” and “bad years?”

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names

Hence, why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch out for when momentum channels into a small number of stocks. Recent Example: Investors could have avoided the Technology bubble had they noticed that large cap technology stocks were artificially inflating the market indexes.  Markets were narrow in 1999, with the S&P 500 (large cap) returning 22.7% while the ValueLine Index (smaller cap) dropped 2.3%.    

8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend

Bear markets rarely bottom out in a simple “V” formation, but instead require some time to base build before the majority of investors become comfortable to rejoin the market. Recent Example: Just look at the S&P 500 Chart over the last Decade; notice the stages of the bear market (1. sharp down, 2. reflexive rebound, and 3. a drawn-out fundamental downtrend).

9. When all the experts and forecasts agree — something else is going to happen

As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?” Going against the herd as Farrell repeatedly suggests can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest. Recent Example: Remember last summer when Oil was at $135 a barrel a vast majority of analysts were predicting oil to continue to rise (some even predicting a $200 price in the near future).

10. Bull markets are more fun than bear markets

Just about everyone can agree with this!

Jim Kopas Investments