Bob Farrell’s 10 rules for investing in tough markets

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Wall Street “gurus” come and go, but in the case of Bob Farrell legendary status was achieved. He spent several decades as chief stock market analyst at Merrill Lynch & Co. and had a front-row seat at the go-go markets of the late 1960s, mid-1980s and late 1990s, the brutal bear market of 1973-74, and October 1987 crash.

Farrell retired in 1992, but his famous “10 Market Rules to Remember” have lived on and are summarized below, courtesy of Jonathan Burton of MarketWatch. The words of wisdom are timeless and are especially appropriate as investors grapple with the difficult juncture at which stock markets find themselves at this stage.

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.

Conversely, markets in free-fall typically spring back as if tied to a bungee cord. Think about the sharp bounce U.S. stocks have had since March 2009, when the Standard & Poor’s 500-stock index was about 80% cheaper.

The market’s recent volatility and investors’ uncertainty suggests that stocks are moving into another downswing. “Because we went so much higher [in the rally from March 2009 through April 2011], don’t be surprised if the correction is a little bigger,” said Barry Ritholtz, an investment manager and chief executive of FusionIQ, a quantitative research firm.

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.

That’s what happened with the “Nifty 50” stocks of the early 1970s, when much of the market’s gains came from the 50 biggest U.S. companies. As their price-to-earnings ratios climbed to unsustainable levels, these “one-decision” stocks eventually capsized.

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

During the week of August 8, U.S. market volatility reached a level not seen since November 1929. Over four consecutive days of trading the S&P 500 moved at least 4% each day — down 6.7%, up 4.7%, down 4.4% and up 4.6% — finishing the week off 1.7%.

Is this the awakening of a bear market? With Tuesday’s close, the S&P 500 is down 12.5% since its April 29 peak. Not the 20%-plus decline that typically marks a bear, but still a confidence-slashing encounter.

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

No kidding.

Source: Jonathan Burton, MarketWatch, August 17, 2011.

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