Peter Lynch’s “One Up On Wall Street” did not just talk about what we in general are better real estate investors. It talks about stocks too. However, before he goes deeper explaining the way he looks at stocks, he gracefully shared in his book the four stages of stock market cycles which I found to be very very useful. He called it the cocktail theory.
Stage one – Everyone avoids a mutual fund manager like a plague. When everyone rather talk about anything else other than stocks, this is the first sign that the market will rise significantly from there. That alone tells you that there is a gloom and doom in the news recently. That, according to Peter Lynch, is the best time to invest. While he confessed that he is not a market timer, this theory is developed over the years.
Stage two – Folks linger around a little longer around a Mutual Fund Manager. At this stage, when folk met a mutual fund manager in a cocktail party, he/she will talk briefly with the manager and tell him how risky the stock market is. And then, they will move over to talk with the dentist. By then, the market is already up roughly 15% from stage one but not very many people had noticed.
Stage three – Everyone asks a mutual fund manager what to buy. When the market is up 30% from the lows, everyone starts gathering around the mutual fund manager and asks what stock he/she should buy, totally ignoring the dentist.
Stage four – Everyone starts giving advice on stocks, even to a mutual fund manager. This is the sure sign of a market top. In a cocktail party, everyone will linger around the mutual fund manager to tell him what stocks he should buy. That sensation is peculiarly true to me about the real estate top in 2004-2005. Folks start telling me and others on how a house is a good investment and how his/her house had risen in value and suggesting me to start flipping real estate.
While Peter Lynch had explained the cocktail theory brilliantly, he does not believe in it to make his investment decision. Ultimately, he believes that undervalued stocks will rise while the most insanely overvalued stock will fall, regardless of where the market is.