You may have heard of Farrell's "10 Market Rules to Remember". Bob Farrell was a Merrill Lynch analyst in the pre-internet era from the 1960s to 1992. Despite an absence of computing power and no on-screen graphics he pioneered technical analysis (charts) and his technical observations attracted attention and gained popular acclaim because of their more realistic 'behavioural' rather than fundamental foundations.
And here they are to save you looking them up:
1. Markets tend to return to the mean over time.
2. Excesses in one direction will lead to an opposite excess in the other direction.
3. There are no new eras, so excesses are never permanent.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
5. The public buys the most at the top and the least at the bottom.
6. Fear and greed are stronger than long-term resolve.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
8. Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend.
9. When all the experts and forecasts agree, something else is going to happen.
10. Bull markets are more fun than bear markets.
As I write, the Dow Jones just fell 300 points and the ASX 200 responded with an almost 100 point fall confirming the new resistance level of 6,000 as something rather more significant that before. In this respect Farrell's eighth Rule comes into focus, namely "Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend". So look out for a "sharp down".
On that subject let me tell you about someone I know who worked on the weapons systems of a Collins Class submarine for 11 years (a bit of a computer whizz) who, in his spare time underwater, would crunch the numbers on the stock market and do a lot of back-testing on trading methods to see if anything systematically worked.
He found some "edges", in particular he found some predictability in short-term trends by identifying and buying into share price breakouts, but one of the things he discovered was that despite the reliability of his system he still got nailed in market corrections and that whatever your system for stocks you always needed a market filter that would cover you for large market movements. That's the problem with a heads-down, bum-up focus on stocks, occasionally you need something that forces you to look up from focusing too hard on the trees, the stocks, when the whole wood, the market, was on the move.
One of his back-tested filters was exactly as Farrell suggested, that corrections start fast and after a lot of experimenting with safety net settings he determined that if the market ever fell 3 per cent in a day you should sell half of everything, and if it does it again you sell the rest, and it applies on any time scale.
If correct, then to protect themselves from a correction, both short- and long-term investors need a mechanical trigger to jolt them out of complacency and inaction and they are wasting their time trying to find that trigger using fundamentals. What causes the first drop that starts a waterfall is irrelevant. It is not the 'drop' that matters but the build-up of water over a long period of time that created the pressure that exploited the weaknesses in the structure that allowed the first drop to appear.
In the case of the US markets, the S&P 500 has risen from 783 to 2119 in 5.9 years, not including dividends. This is the water building up at a compound return of 18.35 per cent per annum, or over 20 per cent per annum including dividends. If earnings had kept pace with prices then it would not matter but they have not.
But before you going running for the hills let me refer you to Farrell's rule number 4. "Exponential rapidly rising or falling markets usually go further than you think". I remember everyone calling the top on the Australian market when it hit the top of its trading range in October 2005. The folly. The end of the bull market didn't happen until two years later when it was 50 per centhigher.
So look for a sharp drop but don't call it until it happens, it may have another 50 per cent left in it.
