By Brian Dolan, Head Market Strategist Bob Farrell was a leading technical analyst at Merrill Lynch for decades, retiring as chief stock market analyst in 1992. During his career, which began in the late 1960’s, he witnessed most every type of market condition imaginable, from bull trends to bear markets and everything in between, including the Black Monday crash of October 1987.
While he based his analysis on technical factors such as price and volume history, he communicated his viewpoints in fundamental, almost story-like terms. At the height of the Great Financial Crisis in late summer 2008, MarketWatch gathered some of Farrell’s more famous observations, and republished them as "10 Market Rules to Remember." We think his list contains some timeless market lessons investors should take to heart:
- 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.
- Excesses in one direction will lead to an opposite excess in the other direction--Think of the market baseline as attached to a rubber band. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.
- There are no new eras — excesses are never permanent--Whatever the latest hot sector is, it eventually overheats, reverts to the mean, and then overshoots. Look at how far the emerging markets and BRIC nations ran over the past 6 years, only to get cut in half. 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 — never is different.
- 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.
- 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. Alternatively, follow a routine of dollar cost averaging and take out the guesswork.
- Fear and greed are stronger than long-term resolve--Investors can be their own worst enemy, particularly when emotions take hold. 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." Take emotions out of the picture by committing to a regular investing plan (say, investing $50 a week), whether the market is up or down.
- Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names--Hence, why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Pay attention to market indicators of breadth (number of stocks advancing vs. declining), and be more cautious when the number advancing narrows significantly.
- Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend--The initial sharp decline is typically triggered by an unexpected event (e.g. Lehman Moment). The following rebound is brought on by bargain hunters thinking the trigger event was blown out of proportion. The prolonged downtrend is usually fueled by the growing realization that a period of fundamental weakness is at hand, with declines fueling further selling.
- When all the experts and forecasts agree — something else is going to happen--As the saying goes: "If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?"Analysts’ forecasts for US interest rates in 2014 were unanimous that they could only go higher. Instead they fell through the entire year (US 10 year Treasury yield from 3.0% in Jan. 2014 to below 2% in Jan. 2015).
- Bull markets are more fun than bear markets--Most investors are going to be ‘long-only’ by virtue of retirement fund holdings such as IRA’s and 401k’s, so a rising market is naturally more enjoyable. But bear markets don’t have to be all bad—they’re an opportunity to add to existing long-holdings at lower prices for brighter days ahead.
***Image taken from venturevillage.eu