After a while, investors adopt rules for themselves. They have been won by many experiences both enjoyed and endured.
Markets are making new highs; the Federal Reserve’s accommodations continue to drive investor enthusiasm; and investors are embracing all good news and dismissing the bad. (Read More: Markets Doubt More Fed Easing Will Boost Hiring: Survey.)
Given these conditions, three important rules come to mind: 1) Trends last longer than investors expect; 2) Don’t fight the Fed; and 3) Market psychology is bullish.
My 1994 mistake: I got out of stocks completely.
After enduring the 1987 crash, when stock prices fell over 20 percent in single day (at today’s levels that would be about a 2,700 point one-day drop, or think Flash Crash times two!), we witnessed a steady climb through 4,000 in the Dow in 1994. I couldn’t believe the incredible rise in share prices, and I believed in a market that would dole out severe punishment for excess.
My wife and I decided reduce our risk and take our money out of the market and buy a second home. The markets climbed for the next 5 years to 11,700. Two pieces of good news: I did not subject my clients to my own fears, and our beach house has kept pace with share gains. But that doesn’t change the fact that I was dead wrong.
Fighting the Fed is easy because it is so easy to second guess any economist. When the Fed suggests the economy is too strong and begins raising rates, it’s easy to look around our individual microcosms and see things not so strong.
When the Fed says things are too weak, we may see things getting stronger. The mistake, then, is when you invest according to your assessment of the world rather than the Fed’s. The Fed has limitless dollars to support its perspective and you do not. Thus the phrase “Don’t Fight the Fed.” It’s usually a losing proposition. (Read More: Farr: Why QE3 May Not Happen Until After Elections.)
In bear markets good news is dismissed and bad news is embraced. My Aunt Constance is a bear on life: She detests optimists and dismisses them as trivial thinkers and not serious people. If a bomb explodes somewhere around the world or a cousin gets stopped for drinking and driving, Constance (never call her Connie) is on the phone to friends and family to wail and rage and savor the suffering. Constance will not buy stocks.
In bull markets, bad news is dismissed, and good news is celebrated. The bull market theme song is “Don’t worry. Be happy!” Don’t worry about Europe, or horrible employment numbers, or a fiscal cliff, or anything else. Just buy!
Presently the trend for share prices is higher. The Federal Reserve has telegraphed a possible third round of asset purchases as well as an extension of the current period of near-zero interest rates for an additional year. Investors don’t want to be bothered by worry-warts. Aunt Constance is miserable! (Read More:Here's What Wall Street Is Saying About the Fed and the Economy.)
As we enjoy these good times, we are keenly aware that prices will at some point reflect the fundamentals, which include the economic backdrop and its effect on earnings growth. Share prices will fall, but we don’t know when. Market timing does not work long-term, no matter how compelling your near-term argument. Owning companies with rock-solid balance sheets, strong cash-flow, high returns on equity, and increasing earnings lets us sleep at night.
There is an ebb and flow to all things, especially stock markets. Enjoy the current ride and benefit, but always position yourself cautiously so that you can endure the quickest downturn when it comes.
Michael K. Farr is President and majority owner of Farr, Miller & Washington, LLC. He is Chairman of the Investment Committee and is responsible for overseeing the day to day activities of the firm. Prior to starting FM&W, he was a Principal with Alex Brown & Sons.
Mr. Farr is a paid Contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, DC, National Association for Business Economics, The World Presidents’ Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle."