Comforting Words, Even Now

Bob Farrell was chief market analyst at Merrill Lynch for 25 years, retiring in 1992. One hesitates to say things like "legend in his own time," but for 16 of his last 17 years at Merrill, Institutional Investor magazine named Farrell the top analyst in predicting changes in overall stock market direction. He formulated a few observations worth noting; here are 10 I thought you'd enjoy. In these rough times, they're strangely reassuring.

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 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, reverts to the mean 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, Human Nature never is different.

4. Exponentially-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.

6. Fear and greed are stronger than long-term resolve. Investors can be their own worst enemies, particularly when emotions take hold. Gains make us exuberant; they enhance well-being and promote optimism. 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. This is why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop.

8. Bear markets have three stages -- sharp down, reflexive rebound and a drawn-out fundamental downtrend. (Farrell suggests that as of August 2008, we are on our third reflexive rebound -- the January rate cuts, the Bear Stearns low in March, and now the Fannie/Freddie rescue lows of July, but that even with these sporadic rallies end, we have yet to see the long drawn-out fundamental portion of the Bear Market. This one wasn't reassuring.)

9. When all the experts and forecasts agree, something else is going to happen. If everybody's optimistic, who is left to buy? If everybody's pessimistic, who's left to sell? Going against the herd 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're long only.