Timing Market Turns

Updated from 8:00 a.m. EDT

Early in my career, I learned that the markets do only a few things: Go up, go down or go sideways. While being on the right side of the trend is crucial, temptation always exists. Can you catch the shift from one trend to the other? Can you time the reversal?

I believe -- with a few caveats -- that you can time markets and anticipate key turns. But before going into specifics, here are some ground rules:

1. You should expect to be wrong.

This concept should guide all of your purchases, but it's especially true when it comes to catching reversals. Before stepping into the fray, you must know at what point your expectations are false. That's your line in the sand, and when it's violated, you are out. No fuss, no emotions -- just some capital preservation.

For example, a close below last Wednesday's reversal day would mean that my thesis -- seller's exhaustion -- is wrong. If that level is penetrated, I'm out. I can always get back in, but I want to avoid getting caught in a cascading waterfall move down.

2. Reversals are processes, not a single point.

V-bottoms are relatively rare, especially after long selloffs. Human nature tends to be tempted too soon, so it's prudent to be patient and slowly scale into positions over time. (Rev Shark mentions the importance of patience constantly.) At this point, market-timers should be about 60% invested and should expect to be almost fully invested (95%) over the next few weeks. I'd also expect to see part of the reversal day retraced, as the rest of the weak hands get shaken out.

3. Without discipline, all is lost.

Gary B. Smith has mentioned several times that every time some hedge fund full of Nobel laureates blows up, it's always because they failed to follow their model. Without a stop-loss discipline that you follow religiously, you shouldn't even think of playing in these waters.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].