Technical analysis is ultimately a visual representation of price and time that is intended to diagnose investor behavior and sentiment.
In so doing, it attempts to divine the booms and busts and trends we see constantly across the markets.
Now, with the market at all-time highs but plenty of negative headlines out there (and many claiming that the current momentum in AI-related stocks is some sort of new paradigm that invalidates long-established rules of the market), we thought it would be useful to revisit some of those market rules, even if just as a counterpoint to some of the tech hype that currently abounds.
To do so, we’d like to highlight the thinking of one of the legends of technical analysis, a man named Bob Farrell, who led technical analysis for Merrill Lynch for 45 years, until 2002, and has devised some interesting market rules.
Here are Farrell’s 10 market rules, which he first put to paper in the late 1990s, when the dotcom boom was well underway.
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Bob Farrell’s 10 Market Rules
- Markets tend to return to the mean over time. Trends that get overextended in one direction or the other will return to their long-term average at some point. The mean itself can trend – indeed, stocks have been in an uptrend since WWII – but extreme variations away from the average get reversed.
- Excess in one direction will lead to an opposite excess in the other direction. Probably the simplest to recognize – after all, markets and sectors boom then bust all the time. Tech stocks got far too expensive in 1999, for example. By 2002, they were far too cheap.
- There are no new eras – excesses are never permanent. When everyone is piling into the hot new thing – meme stocks, NFTs, the Metaverse, some new crypto approach – it’s not hard to find proclamations of “paradigm change” and “this time it’s different.”
- Exponentially rapid rising or falling markets usually go farther than you think – but they do not correct by going sideways. The most interesting of Farrell’s market rules is his assertion that sideways trading doesn’t correct market excesses. Instead, the correction is inevitably delivered by an outright reversal of the initial trend.
- The public buys the most at the top and the least at the bottom. It’s such a well-trod tale that “knowing it was time to sell when my shoeshine guy gave me a stock tip” has become old hat on Wall Street. But there’s no denying that retail investors often provide the bulk of the buying pressures for the aforementioned “hot new thing.”
- Fear and greed are stronger than long-term resolve. Everyone has felt this, probably because of the first part of Rule 4 – market excesses tend to outlast most people’s imagined worst-case scenario. And when things are great, we tend to embrace new-era thinking.
- Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names. This is something that you have likely heard or read from Cabot analysts in the last few years with the rise of the Magnificent 7 stocks. A broad-based rally with participation from small, medium, and large companies is a stronger foundation for a bull market than a narrow rally led by only a handful of stocks.
- Bear markets have three stages – sharp down, reflexive rebound, then drawn-out fundamental downtrend. This rule may be particularly relevant at the moment, given the sharp decline in April and the immediate (and seemingly automatic) rebound to the highs. That is not to say, of course, that we’re teetering on the precipice of a bear market, but it pays to keep this in mind following any sharp selloff.
- When all the experts and forecasters agree, something else is going to happen. Consensus has been in somewhat short supply in the last few months, but the expectations for ongoing rate cuts by the Fed and the assumption that AI is a new growth frontier seem to be prime candidates.
- Bull markets are more fun than bear markets. I think Farrell recognized that it’s easier to make money in a bull market when people are optimistic and, bullish technical signals are more reliable. Thankfully, historically, the stock market is bullish more than it’s not, by about a three-to-one ratio.
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*This post has been updated from a previously published version.
