Executive Summary
Former chief stock market analyst at Merrill Lynch, Bob Farrell, developed 10 timeless rules for investing which are listed below. These are very pertinent given today’s market cycle. Some investors have forgotten the two 50+ percent corrections in the last 20 years. Interestingly enough, over the long-run, missing the upside of an extreme bubble is typically less detrimental than capturing the inevitable downside correction. The two corrections just mentioned recovered more rapidly in the U.S. due to extreme monetary and fiscal policies which were never unwound. See the graph below of Japan’s post-1989 market collapse, which has still not returned to the pre-correction peak. Now for some interesting facts under the hood of this market:
∙ Corporate insiders drastic selling in 2021 (see second graph)
∙ 66% of S&P 500 companies hit 52-week lows while the index hit all-time highs
∙ Divergences abound – time to look “under the hood”
Please proceed to The Details for an explanation of the relationships to watch moving forward.
“The individual investor should act consistently as an investor and not as a speculator.”
–Benjamin Graham
The Details
With over a half a century of investment experience, Wall Street veteran and former chief stock market analyst at Merrill Lynch, Bob Farrell, developed 10 timeless rules for investing. The rules are as follows:
- Markets tend to return to the mean over time
- Excesses in one direction will lead to an opposite excess in the other direction
- There are no new eras — excesses are never permanent
- Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
- The public buys the most at the top and the least at the bottom
- Fear and greed are stronger than long-term resolve
- Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
- Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend
- When all the experts and forecasts agree — something else is going to happen
- Bull markets are more fun than bear markets
These rules become most pertinent as market valuations become significantly stretched from their long-term mean. As has occurred during this bubble, excesses can be stretched far beyond, and last far longer, than was thought possible. This point is encapsulated in rules #3-5. Also, looking at rule #6, one can understand that currently greed has overtaken long-term resolve. And when all of the “experts” tend to agree the market will only continue to rise, extreme caution is warranted. (Rule #9)
However, it is important to realize, no matter how overvalued the market has become, rules #1 & #2 will eventually apply. This is where the vast majority of market analysts commit their biggest mistake. The excitement surrounding a market constantly reaching “new highs” leads them to skew their research in a manner that will keep the party going. And it works for a while. But eventually, markets will turn down and to the “surprise” of many analysts, a lesson in the power of “reversion to the mean” (or correcting to reasonable valuations) is learned.
While it is true, some advisors will err on the side of too much caution on the upside when valuations become stretched. The math eventually proves that missing the “upside” in an overvalued market will typically do far less harm over the full market cycle than capturing both the upside and the downside. For example, the market low in 2009 wiped away all previous gains from about 1996 forward. Now some will point to the fact that the Fed was able to implement extreme monetary policy leading to a bounce back in the market. Here’s the thing, since then, each time the market floundered, it has taken more extreme monetary and fiscal policy to prop it up. The more important point is each time the policy merely builds upon the previous policy. It is never allowed to unwind.
And this leaves the market in a very precarious position. How much more extreme can monetary and fiscal policies become before triggering a major financial crisis? And even so, keep in mind, on an inflation-adjusted basis, the market high in August 2000 was not reached again until the end of 2014 – 14 years later! And in Japan, a country which has led the way regarding monetary policy, with other countries including the U.S., blindly following. Their stock market peaked in 1989. Shortly thereafter, their market collapsed and as can be seen below, over 30 years later has still not returned to the 1989 level.
The current stock market bubble is on shaky ground. As the Fed has signaled, they are reversing their policies which helped blow this bubble. How long before market speculators begin to anticipate a market reversal and begin dumping their holdings? Apparently, some have already begun as corporate insiders have been selling in massive amounts.
And despite repeatedly hitting new “all-time highs,” this market is extremely weak when considering rule #7 above. Last week, via a financial analyst on Twitter, “332 companies in the S&P made a 52 week low last week as the S&P hit an all-time high. This has only happened 3 times in history. All three times were in December 1999.” So, the market index of 500 stocks hit an all-time high, while 66% of these companies hit a 52-week low!
And, renowned economist David Rosenberg Tweeted, “I hate to be a downer before we break out the bubbly, but beneath the veneer, the average Dow and S&P 500 stock is down 10% from the 52-week high. Divergences abound. Sometimes you just have to scratch the surface to see what is really going on.”
Stock market bubbles tend to lead to a lapse in investor memory. Reading Bob Farrell’s rules above tends to lend perspective to the market cycle. The current market is weak as defined by rule #7 and maintains the risks highlighted in many of the other rules. It is important to know what is under the hood.
The S&P 500 Index closed at 4,766 up 0.8% for the week. The yield on the 10-year Treasury Note rose to 1.50%. Oil prices increased to $75 per barrel, and the national average price of gasoline according to AAA remained at $3.29 per gallon.
© 2022. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.
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