Rules of Markets

I haven't posted anything on investments for a bit, so here's a nugget: The wisdom below comes from stock analyst Bob Farrell, courtesy of Big Picture.

Basic stuff, but people in our industry tend to forget it (as do I):

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.

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 to 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. Look at how far the emerging markets and BRIC nations ran over the past 6 years, only to get cut in half.

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.

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. Profits are locked in by selling, and that invariably leads to a significant correction -- eventually.

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.

Watch Investors Intelligence (measuring the mood of more than 100 investment newsletter writers) and the American Association of Individual Investors survey.

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."

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 for when momentum channels into a small number of stocks ("Nifty 50" stocks).

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

I would suggest that as of August 2008, we are on our third reflexive rebound -- the Januuary rate cuts, the Bear Stearns low in March, and now the Fannie/Freddie rescue lows of July.

Even with these sporadic rallies end, we have yet to see the long drawn out fundamental portion of the Bear Market.

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.

10. Bull markets are more fun than bear markets.

Especially if you are long only or mandated to be full invested. Those with more flexible charters might squeek out a smile or two here and there.

I have been the classic, nincompoop investor -- that is, bailing out at the bottom of markets. I did it in silver a long time ago, and I did it in 2003 at the bottom of the last Big Bear.

But just because I've been stupid is no reason that you should be. Since many folks reading this make good salaries sometime and no salaries sometime (and unemployment isn't overly generous), I'll give a few extra tips drawn from hard, personal experience:

Pay yourself first. By that I mean, put money away every week. And don't say "I can't afford it." Brown-bag it to work, get rid of the cable t.v., let the kids go to public schools. Do whatever you must for your money stash to grow.

And where to put the dough?

Feed your 401(k). Put the loot in broadly diversified asset classes (foreign and domestic stocks, bonds, you know the drill). Use the funds that are lowest cost (this will mean -- mostly -- index funds.) And pay attentino to Farrell's market rules above.

Plow money into a Roth IRA. This is good to do because, although you can'ts stuff untaxed dollars into a Roth, all the earnings that you get over the next ten or twenty or thirty years will grow tax free.

Tuck money into a rainy day fund. When you work in the entertainment business, lean times follow boom times as surely as sun follows rain. If you think you're career track will follow a steady, upward trajectory and it actually happens that way, then you are one of the lucky few.

Because, like it or not, Farrell's market rules are a lot like life ... and work careers. We all get an allotment of good days and bad days. The good days are not a problem, but the bad days have to be prepared for.