The Ten Commandments are biblical rules and ethical standards that form the foundation of Judaism and Christianity. Wall Street legend Bob Farrell has created his own set of commandments. Its guidelines provide a basis to help investors reap and retain market profits by better understanding the risks. Disobeying its rules does not entail any legal or moral sanction, but can harm your wealth.
Bob has over 50 years of experience and an excellent grasp of the psychological factors that drive the markets. He is believed to be the first to use the now-popular word “sentiment” to describe market psychology. For those of you who believe in Bob’s Rule # 3, “there are no new erasWe present Bob Farrell’s Ten Timeless Rules of Investing. We wish everyone the best of luck who thinks this time is different.
This article explains its rules and contemplates them especially in today’s environment. You won’t be surprised to learn that the market is breaking many of Bob’s golden rules.
1. Markets tend to mean a comeback over time
“The return to the mean is the iron rule of financial markets” – John Bogle
Asset prices generally follow trends. These trends can be upward, downward or sideways. They can also be straight or diagonal lines or even oscillating lines. Trends are often linked to fundamental or technical factors. Investors are sometimes greedy, pushing prices well above trends. Likewise, investors can be overly cautious and prices fall below the trend.
Bob’s first rule reminds us of an overly stretched rubber band. When prices deviate sharply from their trends, like a stretched rubber band, they tend to pull back and usually in a hurry.
A well-followed example is how stocks and indices trade around their 200-day moving averages (DMA). The chart below shows the range in which the S&P 500 () consistently trades above and below its 200-DMA. It is quite rare for most stocks and indices to travel more than two standard deviations from the 200-DMA. When it does, the chances of a snapback increase.
SPY vs 200 DMA chart
Over the long term, the has followed a polynomial trendline. The colored areas below show the percentage deviations from the trend.
S&P 500 Trend Deviation
Currently, the S&P 500 is about 50% above the 50-year trendline. If Bob’s rule holds and the S&P returns to trend, a correction of around 33% is ahead.
The only other time the market extended from its polynomial trend in the past 50 years was in March 2000. At the time, it was 78.4% above the trendline. Over the next three years it fell almost 50% and fell almost 20% below the trendline, bringing us to rule # 2.
2. Excesses in one direction often lead to excesses in another direction
Rule # 2 is an extension of Rule # 1. Expectations of a retracement to the 50-year trend may underestimate losses if there is an excess in the other direction.
Rules 1 and 2 are valid for prices and ratings. The table below shows 15 different stock valuations that are at or near record highs. The return to their respective means will result in significant draws. Excesses beyond the average will be downright ugly.
S&P 500 valuation table
To better understand what Rules 1 and 2 may contain for the market, we share the CAPE 10, a cyclical measure of the price / earnings ratio.
Based on 120 years of data, a reversion to the mean and trendline results in price drops of 56% and 36% respectively. An excessive return to the lows of 2008 results in a drop of 66%. Strong excessive reversion to previous lows results in an 85% crash.
“With every action, there is an opposite and equal reaction ” – Mr. Isaac Newton
3. There are no new eras – excesses are never permanent
Having looked at where the market is on rules # 1 and # 2, it’s tempting to hope this time around is different. Bob would call this wishful thinking. According to rule # 3, this time is no different, which means that current valuations and prices will eventually return to their norms.
Investors in stocks buy future cash flows. It can be dividends, coupons or profits. Either way, over extended periods of time, expected cash flows and asset values tend to correlate well.
Over short periods of time, however, optimism and pessimism create gaps between economic reality and valuations.
The Buffet indicator is Warren Buffet’s preferred tool for comparing stock market valuations to economic activity. Its simple measure is the S&P 500 market cap to GDP ratio. If earnings and economic growth are adequately reflected in stock prices, we should expect the S&P 500 to rise in line with GDP. The ratio in such a case would be a flat line.
The graph below shows that the ratio hovers around the trend. Currently, the chart involves a 55% correction to normalize the indicator.
Composite market value to GDP
4. Rapidly rising or falling exponential markets usually go deeper than you might think, but they don’t correct by going sideways
The reality of many bubbles is that they rise far beyond what everyone thinks possible. They also tend to correct themselves to much lower levels than most can imagine.
The chart below highlights the emotional stages and price action of a typical bubble pattern.
Emotional stages and price action of bubble pattern
5. The public buys the most at the top and the least at the bottom
Like it or not, retail investors – that is, the public – are often referred to as stupid money. Take it for what it’s worth, as the saying goes by professionals or money says smart.
Bob’s rule makes sense because the audience is generally more sensitive to psychological factors. Greed often gets the better of us. Think how hard it is to sell a stock when it’s up 50%. At such times, investors shy away from selling it because greed accentuates our FOMO (fear of missing out) on additional profits.
Smart money is also susceptible to greed, but they often have risk management guidelines that limit their ability to take risks.
Fear works the same way. There is a Wall Street adage that investors are the only type of consumer who doesn’t want to buy when prices are on sale. The fear of even lower prices is powerful, especially in larger routs when valuations make sense again.
Currently, individual investors are having a blast. By JP Morgan, courtesy of Zero Hedge:
“The estimated net flow of retail investors into US stocks and ETFs from this methodology has hovered at a very high rate of $ 700 million per day in recent weeks (including the week ending July 30). As a result, the monthly net flow for the month of July hit a new high of $ 15 billion, surpassing the previous record of $ 10 billion in June by 50%! “
The graph below shows that the public has invested more in this market than at any time in at least 70 years!
Equities as a percentage of financial assets
Summary Part 1
There is no doubt that investors are ignoring the first five elements of Bob Farrell’s wisdom. If its rules prove to be correct again, investors will have to pay significant costs. Based on the ratings, most investors bet Bob’s rules are outdated and no longer apply. We doubt it.
Join us next week when we follow rules six to ten.