By
Lance Roberts
:
As the markets once again approach historic highs, the overly
exuberant tone, extreme complacency and weakness in the economic
data bring to mind Bob Farrell's 10 investment rules which should
be a staple for any long-term successful investor. Bob Farrell is a
Wall Street veteran with over 50 years of experience in crafting
his investing rules. Farrell obtained his masters degree from
Columbia Business School and started as a technical analyst at
Merrill Lynch in 1957. Even though Farrell studied fundamental
analysis under Gramm and Dodd, he turned to technical analysis
after realizing there was more to stock prices than balance sheets
and income statements. Farrell became a pioneer in sentiment
studies and market psychology. His 10 rules on investing stem from
personal experience with dull markets, bull markets, bear markets,
crashes and bubbles. In short, Farrell has seen it all and lived to
tell about it.
The 10 Rules Of Investing
1. Markets tend to return to the mean (average price)
over time.
Like a rubber band that has been stretched too far - it must be
relaxed in order to be stretched again. This is exactly the same
for stock prices which are anchored to their moving averages.
Trends that get overextended in one direction, or another, always
return to their long-term average. Even during a strong uptrend or
strong downtrend, prices often move back (revert) to a long-term
moving average. The chart below shows the S&P 500 (
SPY
) with a 52-week simple moving average.
(click to enlarge)
The bottom chart shows the percentage deviation of the current
price of the market from the 52-week moving average. During bullish
trending markets there are regular reversions to the mean which
create buying opportunities. However, what is often not stated is
that in order to take advantage of such buying opportunities
profits should have been taken out of portfolios as deviations from
the mean reached historical extremes. Conversely, in bearish
trending markets, such reversions from extreme deviations should be
used to sell stocks, raise cash and reduce portfolio risk rather
than "panic sell" at market bottoms.
The dashed RED lines denote when the markets changed trends from
positive to negative. This is the very essence of portfolio "risk"
management.
2. Excesses in one direction will lead to an opposite
excess in the other direction.
Markets that overshoot on the upside will also overshoot on the
downside, kind of like a pendulum. The further it swings to one
side, the further it rebounds to the other side. This is the
extension of Rule #1 as it applies to longer term market cycles
(cyclical markets)
.
While the chart above showed prices behave on a short-term basis
- on a longer term basis markets also respond to Newton's 3rd law
of motion:
"For every action there is an equal and opposite
reaction."
The first chart shows that cyclical markets reach extremes when
more than 3-standard deviations are above the 50-week moving
average. For the first time since the lows of the market in 2009
this has now occurred. Notice that these excesses
ARE NEVER
worked off by just going sideways.
(click to enlarge)
The second chart shows the price reversions of the S&P 500
on a long-term basis and adjusted for inflation. Notice that when
prices have historically reached extremes - the reversion in price
is just as extreme. It is clear that the current reversion in the
stock market is still underway from the 2000 peak.
(click to enlarge)
3. There are no new eras - excesses are never
permanent.
There will always be some "new thing" that elicits speculative
interest. These
"new things"
throughout history, like the
"Siren's Song,"
has led many investors to their demise. In fact, over the last 500
years we have seen speculative bubbles involving everything from
Tulip Bulbs to Railways, Real Estate to Technology, Emerging
Markets (5 times) to Automobiles and Commodities. It always starts
the same and ends with the uttering of
"This time it is different"
[The chart below is from my March 2008 seminar discussing
that the next recessionary bear market was about to occur.]
(click to enlarge)
As legendary investor Jesse Livermore once stated:
"A lesson I learned early is that there is nothing new in
Wall Street. There can't be because speculation is as old as
the hills. Whatever happens in the stock market today has
happened before and will happen again."
4. Exponential rapidly rising or falling markets usually
go further than you think, but they do not correct by going
sideways
The reality is that excesses, such as we are seeing in the
market now, can indeed go much further than logic would dictate.
However, these excesses, as stated above, are never worked off
simply by trading sideways. Corrections are always just as brutal
as the advances were exhilarating. As the chart below shows when
the markets broke out of their directional trends - the corrections
came soon thereafter.
(click to enlarge)
5. The public buys the most at the top and the least at
the bottom.
The average individual investor is most bullish at market tops
and most bearish at market bottoms. This is due to investor's
emotional biases of "greed" when markets are rising and "fear" when
markets are falling. Logic would dictate that the best time to
invest is after a massive selloff - unfortunately this is exactly
the opposite of what investors do.
The chart below shows the flow of money into equity based mutual
funds.
(click to enlarge)
6. Fear and greed are stronger than long-term
resolve.
As stated in Rule $5 it is emotions that cloud your decisions
and affect your long-term plan.
"Gains make us exuberant; they enhance well-being and
promote optimism," says Santa Clara University finance
professor Meir Statman. His studies of investor behavior show
that "Losses bring sadness, disgust, fear, regret. Fear
increases the sense of risk and some react by shunning
stocks."
The composite index of bullish sentiment
(an average of AAII and Investor's Intelligence surveys)
shows that "greed" is beginning to reach levels where markets have
generally reached intermediate term peaks.
(click to enlarge)
In the words of Warren Buffett:
"Buy when people are fearful and sell when they are
greedy."
Currently, those "people" are getting extremely greedy.
7. Markets are strongest when they are broad and weakest
when they narrow to a handful of blue-chip names.
Breadth is important. A rally on narrow breadth indicates
limited participation and the chances of failure are above average.
The market cannot continue to rally with just a few large-caps
(generals) leading the way. Small and mid-caps (troops) must also
be on board to give the rally credibility. A rally that
"lifts all boats"
indicates far-reaching strength and increases the chances of
further gains.
(click to enlarge)
The chart above shows the ARMS Index which is a volume-based
indicator that determines market strength and breadth by analyzing
the relationship between advancing and declining issues and their
respective volume. It is normally used as a short-term trading
measure of market strength. However, for longer term periods the
chart shows a weekly index smoothed with a 34-week average. Spikes
in the index has generally coincided with near-term market
peaks.
8. Bear markets have three stages - sharp down, reflexive
rebound and a drawn-out fundamental downtrend
Bear markets often start with a sharp and swift decline. After
this decline, there is an oversold bounce that retraces a portion
of that decline. The longer term decline then continues, at a
slower and more grinding pace, as the fundamentals deteriorate. Dow
Theory suggests that bear markets consists of three down legs with
reflexive rebounds in between.
(click to enlarge)
The chart above shows the stages of the last two primary
cyclical bear markets. There were plenty of opportunities to sell
into counter-trend rallies during the decline and reduce risk
exposure.
9. When all the experts and forecasts agree - something
else is going to happen.
This rule fits within Bob Farrell's contrarian nature. As Sam
Stovall, the investment strategist for Standard & Poor's once
stated:
"If everybody's optimistic, who is left to buy? If everybody's
pessimistic, who's left to sell?"
The point here is that as a contrarian investor, and along with
several of the points already made within Farrell's rule set,
excesses are built by everyone being on the same side of the trade.
Ultimately, when the shift in sentiment occurs - the reversion is
exacerbated by the stampede going in the opposite direction
(click to enlarge)
Being a contrarian can be quite difficult at times as
bullishness abounds. However, it is also the secret to limiting
losses and achieving long-term investment success. As Howard Marks
once stated:
"Resisting - and thereby achieving success as a contrarian -
isn't easy. Things combine to make it difficult; including
natural herd tendencies and the pain imposed by being out of
step, since momentum invariably makes pro-cyclical actions look
correct for a while. (That's why it's essential to remember that
"being too far ahead of your time is indistinguishable from being
wrong.")
Given the uncertain nature of the future, and thus the
difficulty of being confident your position is the right one -
especially as price moves against you - it's challenging to be a
lonely contrarian."
10. Bull markets are more fun than bear markets
As stated above in Rule #5 - investors are primarily driven by
emotions. As the overall markets rise - up to 90% of any individual
stock's price movement is dictated by the overall direction of the
market hence the saying
"a rising tide lifts all boats."
Psychologically, as the markets rise, investors begin to believe
that they are
"smart"
because their portfolio is going up. In reality, it is primarily
more a function of
"luck"
rather than
"intelligence"
that is driving their portfolio.
Investors behave much the same way as individuals who are
addicted to gambling. When they are winning they believe that their
success is based on their skill. However, when they began to lose,
they keep gambling thinking the next
"hand"
will be the one that gets them back on track. Eventually - they
leave the table broke.
(click to enlarge)
It is true that bull markets are more fun than bear markets.
Bull markets elicit euphoria and feelings of psychological
superiority. Bear markets bring fear, panic and depression.
What is interesting is that no matter how many times we
continually repeat these
"cycles"
- as emotional human beings we always
"hope"
that somehow this
"time will be different."
Unfortunately, it never is and this time won't be either. The only
questions are: when will the next bear market begin and will you be
prepared for it?
Conclusions
Like all rules on Wall Street, Bob Farrell's rules are not meant
as hard and fast rules. There are always exceptions to every rule
and while history never repeats exactly it does often "rhyme" very
closely.
Nevertheless, these rules will benefit investors by helping them
to look beyond the emotions and the headlines. Being aware of
sentiment can prevent selling near the bottom and buying near the
top, which often goes against our instincts.
Regardless of how many times I discuss these issues, quote
successful investors, or warn of the dangers - the response from
both individuals and investment professionals is always the
same.
"I am a long term, fundamental value, investor. So these
rules don't really apply to me."
No you're not. Yes, they do.
Individuals are long-term investors only as long as the markets
are rising. Despite endless warnings, repeated suggestions and
outright recommendations - getting investors to sell, take profits
and manage your portfolio risks is nearly a lost cause as long as
the markets are rising. Unfortunately, by the time the fear,
desperation or panic stages are reached it is far too late to act
and I will only be able to say that I warned you.
[Extracted from this past week's
X-Factor Report
]
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
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