WWBD? What would Bob Farrell do?
The Ten Commandments are biblical rules and ethical standards that underlie Judaism and Christianity.
Wall Street legend Bob Farrell created his own set of commandments. Its guidelines provide a basis for helping investors obtain and retain market rewards by better understanding the risks.
Disobeying your rules does not entail any legal or moral punishment, but it can be detrimental to your wealth.
Bob has over 50 years of experience and an excellent mastery of the psychological factors that drive markets. He is supposed to be the first to use the now common word “feeling” to help describe the psychology of the market.
For those of you who believe in Bob’s rule 3, “there are no new eras“We present Bob Farrell’s ten timeless rules about investing. We wish good luck to the rest of you who think this time is different.
This article explains its rules and contemplates them remarkably in the current environment. You won’t be surprised to learn that the market is breaking many of Bob’s golden rules.
Rule # 1: Markets tend to mean reversing over time
“Reversal to the average is the iron rule of financial markets” – John Bogle
Asset prices tend to follow trends. These trends can be up, down, or sideways. They can also be straight or diagonal lines or even oscillating lines. Trends are often related to fundamental or technical factors.
Sometimes investors are greedy and cause prices to beat trends. Similarly, investors may be too cautious and prices fall below the trend.
Bob’s first rule reminds us of a rubber stretched too much. When prices deviate greatly from their trends, like a stretched rubber, they tend to retreat and are usually in a hurry.
A well-followed example is how stocks and indices are trading around their 200-day moving averages (dma). The following graph shows the range in which the S&P 500 (SPY) performs constant operations 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, it increases the chances of a setback.
In the long run, the S&P 500 has followed a polynomial trend line. The following colored areas show the percentage deviations from the trend.
Currently, the S&P 500 is about 50% above the 50-year trend line. If Bob’s rule is maintained and the S&P returns to the trend, there is an approximate correction of 33%.
The only other time the market extended its polynomial trend in the last 50 years was in March 2000. At that time, it was 78.4% above the trend line. In the next three years, it fell almost 50% and fell almost 20% below the trend line, which led us to rule no. 2.
Rule # 2: Excesses in one direction often lead to excesses in another direction
Rule number 2 is an extension of rule number 1. Expectations of reversing the 50-year trend may underestimate losses if there is an excess in the other direction.
Rules 1 and 2 are maintained for pricing and valuations. The following table shows 15 different equity valuations located at or near records. The reversal to their respective means will lead to great depression. Excesses above average will be completely ugly.
To help you better understand what rules # 1 and 2 may have for the market, we share CAPE 10, a cyclical measure of revenue price.
Based on 120 years of data, the reversal to the midline and trend line leads to a price reduction of 56% and 36%, respectively. An excess of reversal to the lows of 2008 leads to a decrease of 66%. A severe reversal excess at previous lows results in an 85% block.
“For every action there is an opposite and equal reaction ”. – Sir Isaac Newton
Rule # 3: There are no new eras: excesses are never permanent
After considering where the market is in terms of rules one and two, it is tempting to expect this time to be different. Bob would call that desire thoughtful. According to rule # 3, this time is no different, meaning current valuations and prices will revert to their rules.
Equity investors are buying future cash flows. They can be dividends, coupons or profits. Regardless, over extended periods of time, expected cash flows and asset value tend to be well correlated.
In short periods, however, optimism and pessimism create deviations between economic reality and valuations.
The Buffet indicator is Warren Buffet’s preferred tool for comparing market valuations with economic activity. Its simple measure is the market capitalization ratio of the S&P 500 to GDP. If gains and economic growth are properly reflected in stock prices, we should expect the S&P 500 to rise in line with GDP. The proportion in this case would be a flat line.
The following graph shows the proportion that oscillates around the trend. Currently, the chart implies a 55% correction to normalize the indicator.
Rule # 4: Exponential markets that grow or fall rapidly tend to go beyond what is thought, but are not corrected going sideways.
The reality of many bubbles is that they rise far beyond what anyone thinks is possible. They also tend to correct to much lower levels than most can comprehend.
The following graph shows the emotional phases and price action of a typical bubble pattern.
Rule # 5: The public buys the maximum for the top and the minimum for the bottom.
Like it or not, retail investors, also known as publics, are often called silly money. Take it for granted, as the saying was made by professionals or the so-called smart money.
Bob’s rule is logical, as the audience is usually more susceptible to psychological factors. Greed often gets the best of us. Think about how hard it is to sell a stock when it increases by 50%. Right now, investors don’t want to sell it because greed accentuates our FOMO (fear of getting lost) in additional profits.
Smart money is equally susceptible to greed, but often has risk management guidelines that limit its ability to take risks.
Fear works in a similar way. A Wall Street saying goes that investors are the only type of consumers who don’t want to buy when prices go up for sale. Fear of even lower prices is powerful, especially on larger routes when valuations make sense again.
Currently, retail investors have a field day. By JP Morgan, courtesy of Zero Hedge:
“The estimated net flow of U.S. equity and ETF retail investors derived from this methodology has been 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 July increased to a record high of $ 15 billion, surpassing by 50% the previous record high of $ 10 billion in June. “
The chart below shows that the public has invested more in this market than at any time in at least 70 years.
Summary Part 1
There is no doubt that investors ignore the first five pieces of Bob Farrell’s wisdom. If their rules are accurate again, investors will have to pay serious costs. According to valuations, most investors bet that Bob’s rules are outdated and no longer enforced. We doubt it.
Join us next week as we follow up on the six to ten rules.
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