Fundmastery Blog

Kurt Brouwer June 15th, 2009

I spent three years or so at Merrill Lynch in the early 1980s.  Back then, Bob Farrell was the chief market strategist.  Bob was a pioneer in the area of technical stock market analysis. I remember listening to his technical analysis on the markets on early morning ’squawk box’ calls.  For most of my time at Merrill, the calls were pretty gloomy because we were going through a horrendous bear market for stocks, bonds and real estate.  In fact, it was a time with a number of parallels to this bear market, which has also seen a sharp downturn for stocks, bonds and real estate.

Here are Farrell’s rules on investing that were developed by him over decades of following stocks.  This list came from a MarketWatch piece [emphasis added below].  I have added my comments after those rules I highlighted in bold because I consider them most significant:

10 Rules to Remember About Investing in the Stock Market (MarketWatch, June 11,2008, Jonathan Burton)

…Beginning in the late 1950s, Bob Farrell pioneered 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.

Over several decades at brokerage giant Merrill Lynch & Co., Farrell had a front-row seat to the go-go markets of the late 1960s, mid-1980s and late 1990s, the brutal bear market of 1973-74, and October 1987’s crash. Out of those and other experiences came Farrell’s 10 “Market Rules to Remember.”

1. Markets tend to return to the mean over time

I think there is a good reason Bob Farrell put this one as number one.  When he used the term mean, I believe he meant the arithmetical mean or average return over a long period of time.  The long-term average annual return for stocks over the past 80 or so years is about 8-10%, depending on what time period you pick.  The average is at a low ebb now because we are in a bear market.  Had you checked in early 2000, for example, the average would have been around 11%.

No matter what the average is, the market does not arrive at it in a smooth series of annual returns.  Instead, we see periods of significant underperformance followed by periods of overperformance.  For example, stocks have a negative return for this decade, which is well under the long-term average.  Therefore, at some point, we will have a period of significant outperformance such that stocks return to the long-term average return.

2. Excesses in one direction will lead to an opposite excess in the other direction

3. There are no new eras — 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

When a market such as the stock market or even real estate plummets, it may go further down than common sense valuations would indicate.  That is, stock prices or real estate values, can fall further than makes sense from a valuation perspective. See Market Mood Swings — Revisiting Ben Graham

5. The public buys the most at the top and the least at the bottom

This is self-evident or there would not be tops or bottoms.  By public though, we have to include all investors including institutions.  It is much easier, emotionally, to buy at the top because everyone else seems to be doing it.  It’s much harder to buy at the bottom because almost no one else is doing so.  See Warren Buffett: I May Soon Be 100% Invested In U.S. Stocks

6. Fear and greed are stronger than long-term resolve

Fear and greed are emotional, not rational.  In the post above about Warren Buffett, he suggests being greedy when others are fearful and fearful when others are greedy.  But, in this sense he is using terms in a different way.  He means, being a buyer when others are fearful and a seller when others are greedy.  Long-term resolve is less emotional and more a matter of intellect and will.  For most investors, emotional pulls will overcome intellect and will.

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

I’m not entirely in agreement on this, but I would agree that down markets have phases and those phases can be marked by severe downturns or slow, steady downturns with occasional rallies.  In this bear market, we have had it all, steep slides plus steady deterioration over time with the occasional up day.

9. When all the experts and forecasts agree — something else is going to happen

10. Bull markets are more fun than bear markets

Though most would agree with this last point, I think some experienced investors would disagree.  An investor who has a long-term perspective and cash on hand often feels like a kid on Halloween at the tail end of a bear market because it’s a target rich environment.  However, these same experienced and disciplined investors may feel a bit out of it during extended bull markets because all stocks are going up.

To illustrate this last point, just take a look at what is happening in 2009.  After last year’s debacle for stocks, mutual fund managers are having a great time in 2009 because it is a target rich environment.

Last year, actively-managed mutual funds slightly underperformed versus the S&P 500, but the tide has definitely turned in 2009.  Bloomberg reports that active funds are beating the S&P 500 by the biggest margin in many years [emphasis added]:

Active Mutual Fund Managers Beat S&P 500 By Biggest Margin in 26 Years (Bloomberg, June 15, 2009, Charles Stein)

Mutual-fund managers who pick stocks are beating the Standard & Poor’s 500 Index by the widest margin in 26 years by buying shares of midsize companies such as Sun Microsystems Inc. and Seagate Technology.

Active U.S. equity funds returned an average of 7 percent through May, compared with a gain of 3 percent for the index, a benchmark of the largest U.S. companies. The gap is the biggest since 1983, when funds beat the market by 4.3 percentage points in the first five months, according to Morningstar Inc.

“We’ve been through a period of extraordinary volatility, and that creates opportunities for managers to find mispricings,” said David Kelly, chief market strategist for New York-based JPMorgan Funds, a unit of JPMorgan Chase & Co. that oversees $438 billion.

The agreement last week by New York-based BlackRock Inc. to acquire Barclays Global Investors for a record $13.5 billion put renewed focus on the long-running debate over whether active or index funds produce better returns for investors. San Francisco- based BGI, the world’s biggest money manager, oversees $1.5 trillion, with more than 70 percent in accounts pegged to indexes, including exchange-traded funds.

Diversified U.S. equity index funds declined 38 percent in 2008, less than their active peers, which fell 39 percent. That helped persuade more investors to move to passive investing.

Investors withdrew about a net $230 billion from all U.S. stock and bond funds in 2008, while putting $34 billion into index mutual funds, according to the Investment Company Institute, a Washington-based trade group. Exchange-traded funds, which also follow indexes and trade throughout the day like stocks, added $177 billion through new sales…

There are lots of articles on passively-managed — also known as index — funds versus actively-managed funds.  To me, that isn’t a terribly interesting angle.  I think you can make arguments for both investment styles.  Rather, I think this illustrates that opportunities often spring from crises.

Also, that one year’s results can be interesting and even scary, but one year alone does not mean that much in the long run. Rather than focusing on one year, I believe the goal should be to have a solid, disciplined strategy that you can live with through all the ups and downs of the financial markets.

The 10 rules for investing given above are good to remember, both in bull markets and bear markets.

• Blogging , ETF , Investing , Mutual Funds
• Comments(3)

Did you enjoy this article?

• Subscribe to Fundmastery Blog by e-mail »
• Subscribe to Fundmastery Blog's RSS feed