Farrell’s 10 rules about the stock exchange

Article by Allan Geldenhuys, CFP®

I recently came across an old print out of Bob Farrell’s ten rules about the stock exchange that every investor should know. The name might not sound familiar, but Bob Farrell is regarded by some as an investment legend. He was the chief stock market analyst at Merrill Lynch from 1957 until 1992, and a technical analysis pioneer.

Over the years Farrell experienced all the ups and downs that an investor could encounter when investing in a stock exchange, prompting him to write his now-famous ten rules. The rules have featured in many articles, blogs, and interviews worldwide, but given the current geopolitical uncertainty, US valuations reaching new highs, local markets under performing against peers and the overall negative sentiment, it is worth revisiting his rules:

1. Markets tend to return to the mean over time.

Markets go up, and markets come down, but markets will always return to the long-term moving average. Farrell cited that even if there are prolonged periods of under- or over-performance compared to the long-term trend, the long term moving average is the most realistic return that investors can expect.

2. Excess in one direction will lead to an opposite excess in the other direction.

This rule is an extension of rule 1. Markets that overshoot on the upside will also overshoot on the downside, almost like a swinging pendulum. The further it swings to the one side the further it rebounds to the other side. Understanding rule 1 and 2 can help investors avoid panic buying and selling.

3. There are no new eras – excesses are never permanent."

There will always be a market, asset class or group of stocks that is the “new thing” that elicits speculative interest. Over the years we’ve seen everything from tulips, biotech, emerging markets, property, Dot-com bubble, and commodities being the new thing. As Jesse Livermore puts it: “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.

When the market is reaching new highs or lows, the trend can extend far longer than can be logically expected. The correction of this trend tends to be sharp and never corrected by moving sideways. The 2008/09 financial crisis is a good example of this rule. The JSE All Share index had a record high in May 2008 after a prolonged period of gains. This was followed by a correction of more than 40% when the index hit the bottom in November 2008.

5. The public buys the most at the top and least at the bottom.

Investing 101 states that investors should buy low and sell high, but unfortunately, most retail investors do the opposite and tend to buy stocks as it approaches the top, and to sell or stop buying as it approaches the bottom. This leads to the worst possible investment strategy. Some pundits even view very positive market sentiment as a warning of a market top, and very negative market sentiment as a sign of a market bottom.

6. Fear and greed are stronger than long-term resolve.

When investors allow emotions to cloud their decisions, it normally tends to derail long-term plans. Studies of investor behaviour show that losses lead to fear, and conversely continuous gains lead to overconfidence and greed. These emotions can lead to panic buying and selling at the wrong time. In the words of Warren buffet: “Buy when people are fearful and sell when they are greedy.”

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.

A market rally dominated by a handful of blue-chip stocks or a specific sector is not a sign of real market strength. Ideally investors would like to see a broad-based rally with small- and mid-cap stocks participating in the rise. Naspers comprising more than 20% of the JSE All Share is a very good example of a blue-chip stock that cause a weak market rally.

8. Bear Markets have three stages: sharp down, reflexive rebound and drawn-out fundamental downtrend.

Bear markets often start with a sharp and swift decline. After this decline there is a rebound, and some of the losses are erased. The decline then continues, but at a slower and more grinding pace that often overshoots.

9. When all the experts and forecasts agree, something else is going to happen.

This rule fits in with Bob Farrell’s contrarian investment style. When all analysts have a buy rating on a particular stock, there is only one way left to go. Investors should consider buying when stocks are unloved, and the news is all bad. Conversely, investors should consider selling when stocks are the talk of the town and the news is all good. It is challenging to be a lonely contrarian, especially as price moves against you, but patience gets rewarded over the long term.

10. Bull markets are more fun than bear markets.

With the exception of maybe short sellers this statement is true for everyone. People always want the good times to continue. Bull markets lead to euphoria and feelings of superiority. Bear markets bring fear, panic and depression. The trick is to stay calm throughout the cycle and avoid making irrational decisions.

Allan Geldenhuys, CFP®, is a Wealth Advisor at Autus Private Clients.

Contact Allan Geldenhuys at allan@autus.co.za or 086 107 7789.