Stock Market Rules

Stock Market Rules

If there is one lesson I have learned, in my nearly thirty years of managing investment portfolios, it is that there are no foolproof rules for success in the stock market. Despite the claims of thousands of books, newsletters, and self-proclaimed market guru’s, there is no magic formula. About the best that can be said is that there are certain patterns in the market that seem to be repeated with uncanny regularity. Having knowledge of these patterns can help investors make more informed decisions.

Many stock market observers have noted a variety of these “market tendencies”, but those described by Bob Farrell, long-time chief stock market analyst at a major wall street firm, are very insightful. Although Farrell retired in 1992, his “10 Market Rules to Remember” have remained relevant to market participants. They are summarized here, as reprinted by Seeking Alpha.

1. Markets revert to the mean over time.
When stocks go too far in one direction, they usually 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.

2. Excesses in one direction usually lead to excesses in the opposite 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.

3. There are no “new eras” – excesses are never permanent.
Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots on the downside. As the fever builds in an overheated market, a chorus of “this time is different” will be heard. And of course, it - human nature – is never different.

4. Exponentially 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. Profits are locked in by selling, and that invariably leads to a significant correction, at some point.

5. The public usually buys the most at the top and the least at the bottom.
Follow the sentiment indicators to measure the mood of individual investors.

6. Fear and greed are stronger than long-term resolve.
Investors can be their own worst enemy, particularly when emotions take hold.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of stocks.
Broad momentum is hard to stop. Watch for when momentum channels into a small number of stocks.

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 likely to happen.

10. Bull markets are more fun than bear markets.

So, which of Farrell’s rules should we be most concerned about now? The rule with the most relevance to the current market environment appears to be #8. If bear markets have three stages, which stage are we currently in? We have certainly had the sharp down phase, followed by a reflexive rebound off the March 2009 lows. Will we now enter a drawn-out fundamental downtrend? No one knows for sure, but history tells us that there is some reason to be more cautious now, with the market up nearly 50% from the bottom. Short-term profit taking could lead to a significant pullback. Also supporting this view is #7. Trading volume has slowed and the market has narrowed, with the most significant gains coming from lower quality stocks that had been hit the hardest in the downturn. Narrowing breadth and low volume are not usually signs of strength.
Investors should never depend solely on rules or historical precedents. But these are just one more piece of the puzzle that should be taken into consideration, along with other fundamental factors, when investing in stocks.