Robert ("Bob") J. Farrell was at Merrill Lynch for half a century before he retired in 2004. He published Wall Street's first report on longer-term themes and sector changes in the market.
Beginning in the late 1950s, Farrell was one of the pioneers of technical analysis, which rates a stock not only on a company's financial strength or business line but also on the strong patterns and line charts reflected in the shares' trading history. Farrell also broke new ground using investor sentiment figures to better understand how markets and individual stocks might move.
He ranked first sixteen times in the market-timing category of Institutional Investor magazine's All-America Research Team, and in 1993 he was inducted into the Wall $treet Week Hall of Fame. He is a founder and first president of the Market Technicians Association. Farrell holds a bachelor's degree in economics and finance from Manhattan College and a master's degree in investment finance from the Columbia University Graduate School of Business.
In his years of practice, Farell came up with a list of axioms to keep in mind when investing. The axioms are overlapping and tend to go well with value investing principles, in my opinion. Most of all, they are based on common sense. Let's take a look.
1. Markets tend to return to the mean over time
When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective. This fits in well with the concept of market cycles and business cycles.
2. Excesses in one direction will lead to an excess in the opposite direction
Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline but leads to an overshoot in the opposite direction. According to Farrell:
"It's basically looking at the message of the market. I believe in long- term cycles; there are no new eras, only old eras that go to new excesses, and there is the return to the mean. I have some very simple premises. When you have a boom or a bubble, the same pat- tern follows each time. There is a big break, as in 1929-Â32, and I call that an "A" wave. Automatically that wave goes so far that you get a return move--not a new bull market, but a partial or maybe even full retracement in some cases. Most of the time it's a halfway or a third-of-the-way retracement. That's what I called the "B" wave. Then you go into a long period of markets either going down and making new lows or going sideways for a long time in a "C" wave as the excesses are purged and as what got overvalued winds up being undervalued. I still write about these A, B, C patterns today. A lot of my style sounds more fundamental than technical. That's because I try to integrate the intermarket relationships, for example, the idea that there is a relationship between the gold and the dollar. I com- ment on or try to integrate a lot of different markets into my analy-sis, so I'm a broad generalist with a historical bias."
- Farrell, "The Heretics of Finance"
3. There are no new eras – excesses are never permanent
Whatever the latest hot sector is, it eventually overheats, mean-reverts and then overshoots to the downside. Just look at the long term chart of emerging markets in the sixties and the fever built for the nifty fifty stocks, which were bid up to the extreme level of valuations. The same may now be happening to the tech giants.
As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it – "it" being human nature – is never different.
4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction when the marginal bull turns bearish and tries to lock in his profits. When markets turn south sharply leveraged, investors face margin calls and are forced to sell, and put options are triggered, leading to more selling.
The multiweek "waterfall" we experienced between Feb 19 and March 23 in the present day was likely due in part to this cascading phenomenon. Early bears locked in profit, then there were margin calls, forced selling, etc. Similarly, the massive monetary and fiscal response unleashed the government triggered a sharp reversal that sent the herd stampeding the opposite direction. This was a classic FOMO (Fear of Missing Out) rally.
5. The public buys the most at the top and the least at the bottom
This is why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing. I recommend keeping an eye on "Investors Intelligence" (which measures the mood of more than 100 investment newsletter writers) and the "American Association of Individual Investors Survey." Observe and do the opposite when these indicators reach extreme levels.
6. Fear and greed are stronger than long-term resolve
Investors can be their own worst enemies, particularly when emotions take hold. Gains “make us exuberant; they enhance well-being and promote optimism,” in the words of Santa Clara University finance professor Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.”
If possible, act against them when these sentiments are most powerful. Act with courage and buy when fear stalks the markets, sell when greed rules. At the very least, don't give in to these impulses. Its better to freeze and do nothing than to let emotions rule you.
The CNN fear and greed index is a useful way to track fear and greed in the U.S. stock market. The general idea is to "buy panic" and "sell greed." It order to build character, it's a good idea to always sell something when markets are hitting new highs and buy something when markets are hitting new lows. Investing is all about "delayed gratification."
7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names
This is why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch for when momentum channels into a small number of stocks. There are several ways to track market breadth. One way is the U.S. Market New High Low Index, which tracks the proportion of stocks hitting highs and lows. The advance-decline ratio line is another way to gauge market breadth and direction.
8. Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend
In my vew, as of June 2020, we are on our "reflexive rebound" in the Covid-19 bear market. We have yet to see the long and drawn-out fundamental portion of the bear market.
9. When all the experts and forecasts agree – something else is going to happen
As S&P investment strategist Sam Stovall puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”
Going against the herd as Farrell suggests can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest. Warren Buffett (Trades, Portfolio) is a master of this. Interestingly, Buffett has yet to deploy his cash hoard this time. What could he be waiting for? Is the worst still to come?
10. Bull markets are more fun than bear markets
This is typically true, unless you are short or typically take a more cautious stance.
Read more here:
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- State of Recovery
- A Look at GrafTech: Evaluating Why Mohnish Pabrai Sold
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