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Sunday, August 16, 2009

Ten rules to remember about investing in the stock market

Bob Farrell worked at brokerage giant Merrill Lynch & Co., and had a front-row seat to the rising markets of the late 1960s, mid-1980s and late 1990s. He also experienced bear markets of 1973-74, and October 1987's crash. (thanks to Eric for the email)

Out of those and other experiences came Farrell's 10 "Market Rules to Remember." Reprint of list from Marketwatch, with my spin added.

1. Markets tend to return to the mean over time

This is why you will see chartists often use 50, 100, and 200 day moving averages (DMA) to figure out how far from the mean is the market. In March 2009, when SPX hit 666, the charts showed the market hyper-extended below the mean. This is one of the reasons John Chinnock called for the market to return to 200 DMA.

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

This is my biggest fear for the rally since March 2009, the market rising over 52% in 5 months seems excessive.

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

Back in .com bust of 2000, the media and various analysts called for a new era in computer business models. Profit wasn't needed, "eyes" where. In the real estate bubble from 2002 to 2007, the media and bankers said it was OK to over-leverage, the investment would pay off.

Basically there is NO FREE LUNCH. And excesses in debt being incurred by the government by transferring from private will hit a wall. when is the magic question.

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

Case in point, posting at SPX 930 a good time to sell AND get short. Much better time was SPX 1018 to sell/get short.

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

When I posted time to buy lottery tickets when the market was at SPX 666, how many readers thought that was a good idea? And how many thought it is a good time to sell after the market rallied 47% in 7 weeks? The problem is people look at the short past history for future results. The extremes are not the time to follow direction, but to take opposite stance. Of course, the extremes can go even MORE extreme than expected. Near impossible to state how extreme things will get.

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

Amen to that. I know long term the markets head lower, but the fear/greed of the market roller coaster shakes me from those positions.

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

(marketwatch comment) Markets and individual sectors can move in powerful waves that take all boats up or down in their wake. There's strength in numbers, and such broad momentum is hard to stop, Farrell observes. In these conditions you either lead, follow or get out of the way.

When momentum channels into a small number of stocks, it means that many worthy companies are being overlooked and investors essentially are crowding one side of the boat. That's what happened with the "Nifty 50" stocks of the early 1970s, when much of the U.S. market's gains came from the 50 biggest companies on the New York Stock Exchange. As their price-to-earnings ratios climbed to unsustainable levels, these "one-decision" stocks eventually sunk.

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

We are definitely in a bear market, sharp down from August 2008 to March 2009, reflexive rebound from March 2009. Now what remains to be seen is long downtrend.

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

The experts align at the same time as the public opinion, hence they are typically just as wrong as the public when in agreement. This is one of the reasons why I was nervous on the Obama rally in January, and I should have listened to that little voice, the markets tanked to a low in march of SPX 666. THEN came the Obama rally after everyone was no longer talking about it.

10. Bull markets are more fun than bear markets

2009 will be a textbook example of this statement.

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