Bob Farrell was a seasoned Wall Street veteran, with his career spanning more than five decades making him one of the more respected modern figures in the world of the markets. He is mostly known for his professional roles as the first president of the Chartered Market Technician (CMT) Association and as Chief Market Analyst at Merrill Lynch, where he started as a rookie in 1957 just after business school and worked well into the dot-com bubble.
Just like Jack Dreyfus, he set himself apart from his contemporaries by noticing that there was more to stocks than balance sheets, company reports and fundamental research, despite his initially heavy educational exposure to the tenets of “value” investing.
Stocks that make up the markets tend to behave very differently than what should be expected from the numbers only – companies with amazing balance sheets and books may have flat or down-trending stocks while the market trends up, while stocks of companies without any well-established performance numbers in the first place may lead that market advance from the front lines.
Farrell quickly became interested in technical analysis, market sentiment, investor psychology and other factors that shape market behaviour. His often pioneering work and accuracy in market forecasts repeatedly earned him the title of the leading equity forecaster and listing in Institutional Investor’s Hall Of Fame.
In 1998, he publicized a set of 10 rules that condensed his many learning experiences gained from navigating the markets over many decades and throughout any environment imaginable. Through these varied market cycles, Farrell honed a philosophy that combined both technical analysis and an understanding of human behavior.
Let’s take a glance at each of his rules in detail and see how they can help us weather the storm of the marketplace better. The best way to read them is in sequence, as they are truly a singular flowing argument, much like layers of a pyramid building on each other. Each successive rule overlays with and reinforces previous rules.
I – Over time, markets tend to reverse to average
This first one starts off easy, introducing specifically passive long-term stock buyers to the general character of the market. Farrell comments that the stock market follows a ultra long-term trajectory to the upside, which for the popular American stock indices returns somewhere between 6-13% annualized, depending on the index and the time-frame you are looking at.
This however does not mean that any given year a long-term buy’n’hold “investor” will make such a return every year. Some will be higher, some much lower, many even in the negative.
Think of the trajectory of the uptrend as a linear line tilted upwards, which thus represents an average that runs over time. Stock indices though show regular aberrations from this average, dipping and rallying, just to retreat back to the average directional move eventually. Markets will rally hard, just to fall back. Markets will sell off hard, just to rally again. There will be bull markets containing numerous downside corrections, and there will be bear markets interspersed with quite violent rallies to the upside.
An index may sell off a few days, just to rally back to where it was. It may rally hard, only to start dropping from there back again to a level where market participants as a group are willing to buy again. These undulations together, seen over given time-frames, will form trends within trends, just like fractals – and each of these trends reflects an “average” directional move, as you can see for example in the below chart of the S&P500.
Over time, a given stock index will retreat back to the current trend, or “average” directional move, whether that’s the uptrend in a bull market or the downtrend in a bear market, and the current trend itself will eventually align with the ultra long-term trajectory again.
An average as measured over decades, years, months or weeks though does not predict what will happen in any given year, month or week. As the legendary JP Morgan once stated, “markets will fluctuate”. We do and cannot know how long specifically a deviation from the average will take place, but there is no way around the eventuality that the deviation must trace back to its own average over time, and most likely will even overshoot it in the other direction (see Rule 2).
All this is grounded in the composite psychology of the market participants. When prices become high, a lot of people sell to take profits, depressing prices. The falling prices will make more people sell out of fear of losing profits or sitting on losses, magnifying the move back to average. Once price has fallen enough, new groups of buyers will step in, giving buying support and leading to yet another countermove. To read more on this phenomenon, please refer to my Stock Speculation Bundle, where I go into much greater detail on the psychology of market cycles.
II – Actio et Reactio: Excess in one direction will lead to excess in the opposite direction
In line with Newton’s famous law, the stronger a deviation from the average directional trend is, the stronger will be the counter-reaction back or below the mean. In this context, markets behave just like a pendulum – the more it is displaced in one direction, the harder it will swing in the other.
Looking back at the figure above, it becomes especially clear that very strong moves to the upside are followed by violent moves to the downside, far undercutting the “average” directional move, or trend. Should an undercut to the downside become too radical, it will be followed by breathtaking rallies.
This again is rooted in psychology. Market extremes are predicated on psychological extremes and emotional excess in either direction. Market tops and bubbles bring in amateurs that emotionally gamble with money and increase margin debt to astronomical levels (assumed leverage of traders), all of which become a breeding ground for firepower to violent and prolonged sell-offs. Market bottoms features tons of cash sitting available to be invested, but are also fraught with despondence, fear and pessimism – a genuine new rally in equities is doubted by the masses and will have barely anyone on board that would be inclined to sell early, thus the rally can shoot off violently by large buying of the “smart” market participants who have been waiting, without any significant profit-taking holding the new advance back.
Tying in with Rule 1, markets will retreat back to an average trend over time, but the more a stock index (or a stock for that matter) deviates from its own “average” directional trend, the harder it will correct back to and beyond it.
III – No such thing as ‘a new era’ or ‘this time it’s different’
Every time markets become too exuberant and any healthy awareness of risk is thrown out of the window, we hear about certain glamour stocks and the companies behind them bringing in a ‘new era’, and that markets will not eventually retreat back to the average because ‘this time it’s different’.
This has happened near every major market top, be it dot.com, Nifty Fifty, the Go Go years, back to the 1929 top, just to name a few. In 1932, Graham and Dodd noted that it was during times of market euphoria, people start throwing caution out of the window due to a supposed ‘new era’ arriving that overrides all past experience. This mindset, they described, manifested as follows: “It was not that a stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price.”
It’s not you, it’s me … it’s not that markets are out of whack, it’s that ‘the standards have shifted permanently’. Bob Farrell realized that the problem with this thinking is that when people argue for a new era overriding cautionary measures of the past, they fail to realize that the whole history of civilized mankind is merely an endless string of such new eras. Take a peek at the below timeline, and merely eyeball the last century – from steel industry & railroads, to automobiles, aircrafts, radios, to PCs, to new frontiers in pharma, to microchips, the internet, the blockchain, and now AI.
Each time a ‘new era’ appeared, it peaks out eventually, just when the party in the markets is the loudest. Market bulls proclaim that ‘everything is different’, but the sobering reality is that it’s all just the same – a cycle repeats, and every cycle ends when the misallocation of resources due to exuberant malinvestment of the last new era is starting to wash out. Markets WILL retreat back to the average, irrespective of how revolutionary that new technology is that markets are chasing – it has happened every time since markets existed.
IV – Exuberance and panic can go much further than you may think
Extreme deviations from the average can and will become more extreme than most people believe.
Market tops can develop into drawn-out see-sawing “whipsaw” markets, or parabolic rallies and even speculative bubbles spanning months or years – just look up the 1929, 1937, 1968, 1987, 1998 or the dot.com tops. Here, indices may rally in excess of 25% or much further per year – the NASDAQ Composite ran up 95% in 100 days in 1999-2000 – all while leading stocks may explode hundreds to thousands of percent. The tulip mania or the South Sea bubble are other examples where unbelievable price advances manifested in a short amount of time, propelled by excess.
Market panics can kill accounts by violently pushing stocks off a cliff, or by long soul-crushing downtrends. In October 1987, during the flash crash, the SP500 fell -29% in 3 days. In 2008, indices fell just shy of -50% in less than 100 days. In 2020, markets cracked -36% in 22 days. In 2000-2003, the NASDAQ Composite shed -78% in 3 years, destroying wealth of a whole generation of stock holders.
Such extremes are formed and exacerbated because, again, they lie rooted in psychology. Fear and greed reign supreme. Recent returns kickstart the ‘hot hand’ fallacy, making people believe that things will keep going the way the have been going. Because such moves are not driven by valuations or facts but emotions, they will behave like emotions – spiraling down or up in wild excess, sucking in the careless and spitting them out well-digested.
As discussed above, “new era” thinking leads even well-grounded individuals to throw any caution in the wind and go all-in late in a market advance (see next Rule), and extremes are formed when the large mass of market participants starts accepting such as the new normal and acts on this notion, driving markets up against the disbelief of even the smartest market analyst.
Bear markets or market crashes find their extremes shaped by fear, despondence, hopelessness, or even panic that the world we know has ended and markets will never recover (think of the 2020 COVID panic, or the panic of 1907). While it was clear that excesses needed to be washed out post the dot.com era, most professional money managers believed believed well into a year after the 2000 top that markets would be back at normal again after correcting -20% and should start lifting up any moment again. In reality, the NASDAQ bear market would pull back >70% and take more than 3 years to unravel.
The important thing here to grasp is that initially few people believe that a wondrous advance or drawdown can go any further than it has already gone. In fact, bubbles, bear markets and panics can only happen because initially almost everybody doubts them. People are still stuck in the mindset of what the markets have been doing in the recent past their memory encapsulates, i.e. not what they are doing right now. Eventually though, almost everybody will expect it to go on, as the ‘right now’ becomes the new normal. As we will see in Rule V, this tends to form yet another extreme in the other direction.
V – The public is always wrong
When excess enters the market, it is brought about by consensus thinking of the majority of market participants. The concept of contrarian thinking posits that this consensus is a warning signal to the shrewd observer (more on this below).
The ‘public’ here does not only refer to amateurs and mom-and-pop investors, but equally encompasses a lot of money- and fund managers. In fact, a more fitting label for ‘public’ is the slightly vulgar term ‘dumb’ money: People who follow commonplace investment strategies and Wall Street wisdom, consume manipulated financial news, practice inefficient or no risk management, and who do not believe that emotions and sentiment are one of the main drivers of the markets. They stand in contrast to the ‘smart’ money – market participants with clinical methodologies, proven track records, astute risk management – people who can objectively assess markets and are always a step ahead.
The dumb money will stay away from the best opportunities at the end of a bear market or deep correction due to fear, which is when the smart money makes money hand over fist. When glowing market news coverage becomes abundant, and the general understanding of the markets swings to ‘safe’, they pile in – typically right near a top. Greed sets in, which in turn is used by the smart money to unload their holdings for profit.
All this however does not mean that public consensus tipping in any one direction is a timing signal, or a state of black-and-white. Far from it. Public consensus is a condition, a baseline that needs to be present for something else to happen, something that increases the probability of the markets turning at any one time. It does not mean that what you are waiting for or diagnosing will happen soon, and it manifests gradually over time.
There is an old saying that contrarians are always right but never on time. Eventually, the boat will tip over when the public all starts sitting on one side, but those who act on contrarian impulses will often go bankrupt before any chance of profiting from their impressions. Remember Rule 4, excesses may go on longer than you think, or as Keynes put it, “the markets can stay irrational longer than you solvent“.
We cannot predict what will happen. The best we can do is determine conditions (what Jesse Livermore referred to as basic conditions), and position ourselves in accordance with them and our read of the market.
VI – Fear and greed are stronger than long-term resolve
This next Rule emphasizes that the factors driving market excess can easily overpower those that believe they will ‘hold through the dip’ and not get sucked into buying more near an exuberant top. Understanding this is very important to those labelling themselves long-term buy’n’hold or value investors – if you do not think that your emotions cannot overpower you, then you ARE the type of fool that the market loves to grind to dust.
While there are those that truly can emotionally stand holding large swaths of typically blue-chip stock through a bear market such as the 2008-09 crash until prices may recover, the cemeteries of the world of finance are filled with graves of those that thought they could, just before they succumbed to greed buying into the top and in panic selling just near the bottom. The amount of wealth that has been destroyed by not giving emotional impulses enough respect is beyond calculation, but it will lie in the hundreds of trillions of dollar even just for the last few decades.
Of course, prices may never recover, and holding through should be discouraged in any case. We tend to look at indices to analyze bear markets, but even if you held something akin to an ETF in 2000, you would not have gotten back to breakeven until decades later – again, many people would have sold in despondence to just ‘get out what little is left’. But the dumb money and funds typically hold individual shares and not broad market instruments, any many of those never recover after bear markets. Just look at some banking shares after the 2008-09 bear market to sober you up.
VII – Advances predicated on a few blue-chip glamour stocks are weak
Stock indices fascinate anyone glancing at them, and it is easy to see why – the old idea of one picture telling more than a thousand words. When people speak about stocks or the stock market, they are typically referring to an index such as the SP500 – because they are averages, baskets of stocks supposed to show the average move of stocks as an aggregate over time.
Though this may be true for some rare indices, the majority of the popular ones such as the SP500, the NASDAQ-100, the Dow, the NYSE Composite, are calculated as weighted by the market capitalization of their components. This due to an assumption that larger “blue-chip” companies are more important to economic calculations as they employ more people, have larger revenues, etc.. Whether you agree with this notion or not, this mode of calculation can lead people astray when only the stocks of the biggest companies perform well when the rest of the market flounders.
Typically, near the later stages of market rallies or during extended and drawn-out tops, we will see indices grinding continuously up, while a look under the hood of market internals reveals that in fact those averages are only held up by a small number of such blue-chips, due to their heavy weight in the index calculations.
In that case, merely the largest companies are profitable and their stocks driven up on earnings-related money inflows from mutual funds and the public. This however is almost always the case in such late-stage environments. The individual companies making up the large-cap blue-chip category change every time, but it is true every time that they are the last runners into tops such as 1929, 1972 or 2000, and they tend to underperform the market after such major tops for decades.
Seeing a thinning market predicated on the concentrated performance suggests that you are entering weakening environment. It does not mean that the market can’t rally on substantially and make long-term holders money; it just means that the risk of being in that market is rising, and typically such environments do not harbor a rich segment of individual stocks fit for making large amounts of money trading in them.
VIII – Bear markets have three stages—sharp down, reflexive rebound, and a drawn-out fundamental downtrend
A technical description, of how bear markets are rooted in psychology.
The first sudden selloff, forming a first ‘leg’, is typically sudden and unexpected by the majority of market participants. It is heavily doubted and seen as a temporary pullback, an opportunity to ‘buy the dip’. This almost automatic buying of a large mass of market participants seeing what in their eyes are ‘bargain’ prices lead to a short-lived rally, the ‘reflexive rebound’. This rebound can bring prices quickly up again or even launch the indices into slightly new-High territory.
The rebound rally, also known as ‘dead-cat bounce’, is not driven by large amounts of buying power however. It is driven by amateurs, while the smart money is sitting on the side, awaiting this rally to restart their selling into the higher price again. This dynamic can repeat a few times, but will eventually turn the tides of the market into the indices making lower Lows. As more and more market participants start seeing the dropping prices, selling increases due to fear of lost profits (or actual losses after buying into a top), while another large segment of market participants will start shorting shares.
Depending on the excess of the previous environment, and economic sentiment, this will start the last stage of the bear market, the ‘fundamental downtrend’ which can last from a few months to multiple years. Recovery is not easily spotted, but will come one day as sure as the sun will rise tomorrow in the east.
IX – When everybody sits on one side of the boat, it will topple over
Another twist on ‘the public is always wrong’.
When most people agree that an advance will continue, it probably won’t – because everybody who thinks the market will head up has already bought shares to profit off of that move, and there is few buying power left to drive the markets up. The only thing they can do is sell (typically catalyzed by some external news event), driving prices down.
When most people think that a bear market will keep going on, it will most likely bottom out soon. This is for the same reason as above, but in reverse. Since most people believe that prices will keep dropping, they have already sold their holdings to not lose more, or are straight out short the market. No selling power is left anymore, and the smallest rally will squeeze shortsellers into buying to cover their positions – should fundamentals look favorably, a new uptrend will start predicated on large buying pressure by the smart money.
X – Bull markets are more ‘fun’ than bear markets
When it comes to stocks, Wall- & Main street and legacy popular media will only ever spank the bull trope. Money can only be made ‘long’ stocks, and selling shares short is ‘immoral’.
This makes sense, as humans always have a baseline sentiment of hope and betterment of things in the future, which translates into the ultra long-term upwards trajectory of the stock market.
The usage of the word ‘fun’ again implies that a lot of people will see the stock market as something akin to entertainment, something to participate in emotionally, and something worth fighting for. This all sums up the emotionality of amateur investing – seeking fun, defying the ‘bears’ and making money on future prospects. Though bearing a kernel of truth, this idea is a dangerous one to embrace, and hast lost a lot of people a lot of money – participating the markets should be done objectively, with a clear set of rules.
I hope these rules, despite their relatively basic nature, were able to help you understand the gears working inside that ever-morphing machine we call the stock market a little bit more.
If you are interested in more fine-grained and useful knowledge on how the stock market works, feel free to check out my free introduction bundle into the world of stock trading here.
So long,
TGS
