Graphs & Narration courtesy- Lance Roberts, Real Investment Advice
Who is Bob Farrell? Bob is a Wall Street Veteran With Over 50 Years Of Experience
– Markets tend to return to the mean (average price) over time
When a rubber band is stretched so far, it must be compressed until it can be stretched again. The same holds true for stock prices that are tied to their moving averages. Trends that become overbought in one direction or the other often revert to their long-term average. Also in the midst of a solid uptrend or downtrend, prices often return (revert) to a long-term moving average.
– Excesses in one direction will lead to an opposite excess in the other direction
Like a pendulum, markets that overshoot to the upside will also overshoot to the downside. The more it swings to one side, the more it swings around to the other. This is the application of Rule #1 to longer-term business periods (cyclical markets).
Although the map above depicted how stocks respond in the short term, markets often react in the long term to Newton’s third law.
– There are no new eras — excesses are never permanent
There will always be a “different trend” that piques people’s curiosity. Many investors have perished as a result of “new stuff” throughout history, such as the “Siren’s Song.” In reality, speculative bubbles have popped in everything from tulips to railways, real estate to technology, emerging markets (5 times), automobiles, and commodities over the last 500 years. It always begins with the first.
– Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
The irony is that market excesses, such as we’re seeing now, will go far deeper than theory would suggest. However, as previously said, these excesses are never played out easily by trading sideways. Corrections are still as harsh as the advancements were thrilling. When the markets break out of their directional averages, corrections followed quickly.
– The public buys the most at the top and the least at the bottom
At market highs, the average individual investor is most bullish, while at market bottoms, the average individual investor is most bearish. This is attributed to investors’ emotional prejudices of “greed” in – markets and “fear” in declining markets.
Logic would suggest that the safest time to buy is following a big sell-off; sadly, investors do the absolute opposite.
– Fear and greed are stronger than long-term resolve
Emotions cloud your decisions and impair your long-term strategy, as specified in Rule #5.
“Gains make us ecstatic; they improve our well-being and foster optimism,” says Meir Statman, a finance professor at Santa Clara University.
“Losses carry sorrow, disgust, apprehension, and regret,” according to his research on investor behaviour. Fear heightens the perception of fear, and some people respond by avoiding stocks.”
The bullish optimism index indicates that “greed” is resuming to levels where shares have traditionally hit intermediate-term peaks.
– Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
The importance of breadth cannot be overstated. A rally with a narrow breadth means that there will be reduced attendance and that the odds of failure will be higher than normal. With just a few large-caps (generals) leading the way, the index cannot continue to rise. To lend the rally legitimacy, small and mid-caps (troops) must also be on board. A rally that “lifts all sails” denotes broad support and raises the likelihood of further gains.
The ARMS Index is a volume-based metric that analyzes the relationship between advancing and decreasing issues and their respective volume to ascertain market intensity and breadth. It’s typically used as a short-term market strength indicator. The table, on the other hand, indicates a weekly index smoothed with a 34-week average over longer time spans. Spikes in the index have traditionally corresponded to price peaks in the short term.
– Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
Bear markets often begin with a sharp and rapid drop. There is an oversold rebound after this downturn that retraces a portion of the decline.
As the dynamics deteriorate, the longer-term downturn persists, but at a slower and more grinding speed. According to Dow Theory, bear markets have three down legs and reflexive rebounds in between.
The phases of the last two primary cyclical bear markets are shown in the graph above.
The case to be made is that there were several ways to sell into counter-trend rallies and reduce risk exposure during the downturn.
Regrettably, the newspapers and Wall Street advised buyers to just “hang on” before they were forced to sell at the bottom.
– 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?
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.
– Bull markets are more fun than bear markets
Investors are mainly motivated by feelings, as specified in Rule #5.
If the overall prices grow, the overall trajectory of the economy dictates up to 90% of every particular stock’s price change, hence the expression “a rising tide raises all vessels.”
Investors begin to assume that they are “wise” as the stocks grow and their portfolio is increasing. In fact, their portfolio is predominantly driven by “chance” rather than “knowledge.”
Investors act in a similar manner as people who are addicted to gambling.
When they succeed, they feel their success is due to their abilities. When they start to fail, though, they want to gamble.