10 Market rules to remember

Wall Street ‘gurus’ come and go, however, Bob Farrell has achieved legendary status. He spent several decades as chief stock market analyst at Merrill Lynch & Co. and had a front-row seat at the go-go markets of the late 1960s, mid-1980s and late 1990s, the brutal bear market of 1973-74, and the October 1987 crash.

Farrell retired in 1992, but his famous “10 Market Rules to Remember” live on. These are summarised below, courtesy of The Big Picture and MarketWatch (June 2008).

According to Dr Prieur du Plessis, Plexus group chairman, Farrell’s words of wisdom are timeless and especially appropriate as investors grapple with the difficult juncture at which stock markets find themselves at this stage.

1. Markets tend to return to the mean over time. When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.

2. Excesses in one direction will lead to an excess in the opposite direction. Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.

3. There are no new eras - excesses are never permanent. Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots. Look at how far the emerging markets and BRIC nations ran over several years up to late 2007, only to have their gains halved in less than a year. As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it – human nature – is never different.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways. Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction eventually.

5. The public buys the most at the top and the least at the bottom. That’s why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing.

6. Fear and greed are stronger than long-term resolve. Investors can be their own worst enemy, particularly when emotions take hold. Gains make investors exuberant and promote optimism, which encourages us to invest more money even when markets are overbought and don’t offer good value. Losses bring sadness, disgust, fear and regret, which encourage us to sell at rock-bottom prices or not to buy when bargains are staring us in the face.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. This is why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch for when momentum channels into a small number of stocks.

8. Bear markets have three stages - sharp down, reflexive rebound and a drawn-out fundamental downtrend. To put these stages in perspective, David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, provided a graphic illustration of Farrell’s three stages (see accompanying graph).

“Given the current debate as to as to whether the US stock markets are experiencing a primary (secular) bull market or a rally within a primary bear market (a so-called cyclical bull market), Farrell’s rule number 8 provides much food for thought,” says Du Plessis.

“Whether stock markets will enter a drawn-out downtrend remains to be seen, but given the magnitude of the rebound a pullback certainly looks likely,” comments Du Plessis. “Caution seems to be in order.”

9. When all the experts and forecasts agree - something else is going to happen. According to Du Plessis, a recent CNBC poll revealed that 90% of Wall Street economists believe the recession has ended. “The latest survey among investment advisors by Investors Intelligence also showsthe proportion of bulls is now at the highest level since December 2007 and the proportion of bearsat the lowest level since October 2007,” he adds.

Going against the herd as Farrell repeatedly suggests can be extremely profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest.

10. Bull markets are more fun than bear markets. This holds true especially if you are long only or mandated to be fully invested. Those with more flexible charters might squeak out a smile or two here and there.

Du Plessis reminds local investors that the South African stock market will react in sympathy to any decline in the US stock markets. “After a rally of just over 38% in five months from the 3 March 2009 low, I believe the JSE is due for a pull-back. Clients with lump sumsshould rather phase money into the market over the next three to four months to avoid the risk of investing at a possible short-term top,” says Du Plessis.


Source: Gluskin Sheff & Associates - Lunch with Dave, August 7, 2009