Peter Lynch’s “One Up On Wall Street” didn’t just talk about what, in general, we are better real estate investors. It also talks about actions. However, before delving into the explanation of how he views stocks, he gracefully shared in his book the four stages of stock market cycles that I found very, very helpful. He called it the cocktail theory.
Stage one – Everyone avoids a mutual fund manager like the plague. When everyone prefers to talk about anything other than stocks, this is the first sign that the market will rise significantly from there. That alone tells you that there is a sadness and pessimism in the news recently. That, according to Peter Lynch, is the best time to invest. Although he confessed that he is not a market timekeeper, this theory has developed over the years.
Stage two – People hang around a mutual fund manager a little more. At this stage, when people place a mutual fund manager at a cocktail party, they will briefly talk to the manager and tell them how risky the stock market is. And then they will move in to talk to the dentist. By then, the market is already up about 15% from stage one, but not 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 asking him what stocks he should buy, completely ignoring the dentist.
Four stages – Everyone starts giving advice on stocks, even a mutual fund manager. This is the sure sign of a market peak. At a cocktail party, everyone will hang around the mutual fund manager to tell him what stocks to buy. That feeling is particularly true for me about the real estate top in 2004-2005. People start telling me and others about how a home is a good investment and how their home has increased in value and suggest that I start investing in real estate.
While Peter Lynch had brilliantly explained the cocktail theory, he did not believe in it when making his investment decision. Ultimately, he believes that undervalued stocks will rise while the most incredibly overvalued stocks will fall, regardless of where the market is.