The first rule of being a bull market is that you don’t want to get out before the party is over.
There is a world of difference between investing in a poor company in the dying months of an improving bull market, and the young investor who believes that in the next few weeks everything will go up. He is doomed to disappointment, especially if it is a retail investor or one who likes to pick stocks.
The most important mistake to make when investing in a market that is likely to last is to not get the signals early enough. Investors forget to monitor market conditions at a time when there are no historic examples of trend reversals that allowed for time to develop.
The most common myth is that the average market continues its rally because a quirk of calendar timing is keeping the price up.
In reality, this hypothesis only becomes viable around the first anniversary of a new market low and rarely is there a full year of further gains between the trough and the peak. Research shows that when the markets experience a decline and price has not yet made a new high in the new year, the likelihood of a new high within three months is very high.
In other words, just because the past three-month period shows weakness and stock prices have yet to make a new high, it is not in the price yet. There is no hope of a gain in value to lead us to believe we have to wait until the next bottom to buy.
Just because the past three-month period shows weakness and stock prices have yet to make a new high, it is not in the price yet
A glance at charts can confirm a bear market when a bearish move shows a bearish cross, but neither the bearish cross nor a bearish divergence is necessarily a sign of a market in bear territory.
The most telling indicators — like commodities, who are indicators of investor sentiment, or interest rates, who are indicators of the health of the economy — are more positive than negative. It is this bottom-up observation that works best with individual stocks.
Some investors do the best work within their own portfolios by waiting out a bear market and missing out on the first earnings season when enthusiasm is at its peak, when the business cycle is strong, or even when the Fed tightens — a cycle which has a bearish correlation with a stock market bear.
It is important to pick stocks that appear to be showing signs of deteriorating fundamentals. However, since stocks are inherently cyclical and will reflect the fundamental changes over time, the strength of their relative price performance is far more important.
I suspect that over the next few years it will be far easier to predict when the markets become overvalued and overbought than it will be to predict when they are undervalued and oversold. The important thing to note, however, is that the markets may be oversold at the same time that they are overvalued.