Come On, Can You Really Know If the Stock Market Will Go Up or Down?Amidst the talk that no one knows for sure where the market is headed, the smart money is measuring probability by observing the many clues for whether the stock market is more likely to go up or down at any given point in time. Remember, with investing, we only have probabilities. That is all Warren Buffett has, that is all financial advisors have, and that is all you and I have. While probability is far from certainty, wise investors consider probability from available information and observation. First, reliable fundamental data on PE ratios, yield curve inversion, and various economic activities all provide valuable tools for predicting stock market direction. Second, technical analysis provides another slew of revealing data for forecasting whether the stock market will go up or down. In addition to fundamental and technical analysis, there’s plain ole common sense; this is where Bob Farrell’s rules enter the picture. We can all relate to this, even though you may choose not to at times if you’re anything like me. Amidst the non-stop promotions for passive investing in the trillion dollar financial services industry, the smart money is looking at all the above for estimating probabilities for market direction. So, let’s make the most of this free and revealing information in guiding us, too, toward whether the stock market will go up or down in the near term to aid us in preserving and building our own wealth.
Bob Farrell’s 10 Market Rules to RememberBob Farrell’s 10 Market rules can significantly help every investor avoid the ongoing hype and herd mentality about stock investing to gain a much better understanding of the overall stock market and whether it is more probable to go up or down over the next few years. These rules provide an insightful big picture perspective that can get lost in tracking portfolio performance. It pays to step away from your own investments and look at the big picture. Big pictures reveal a lot that can help keep you on track to reach your retirement goals with a smile on your face. For more on this, read my related post How Much Longer Until I Can Retire? Below are Bob Farrell’s 10 Market Rules to Remember.
1. Markets Tend to Return to The Mean Over TimeMost stock investors know that there is an average amount the stock market moves up over time; this average is the reason people invest in the stock market in the first place. They plan to get a certain return based on what stocks have done in the past. Over very long time frames, this annualized stock market return is 10%. (Remember, this often used return number includes dividends reinvested and compounded, and retirees don’t reinvest dividends if they are living off investments.) A mean is a type of average. While a 10% average annual return sounds great, the occasional wild swings down that contribute to that average aren’t too great. In fact, if those wild swings down hit in the few years before or after retirement sequence of returns risk can destroy an otherwise good retirement plan. A perfect example is the stock market crash in October 2007 through March 2009 when the S&P 500 dropped about 54%. You can easily see how different it feels to think about making 10% a year on the stock market vs seeing your stock portfolio decline by 54%, but it helps to know that stock prices change to mean back toward the average. Returning to this average, or mean, is called mean reversion. Theory statistician Francis Galton first observed it. It explains the way normal events follow extreme events. (1.) During the pain of bear markets, it’s important to remember that stocks will eventually revert to the average by going back up over that average. Likewise, during the plentiful times when stock market values have swung up higher than the average valuation, it’s smart to remember that they’ll need to swing way back down under the average to get back to the usual average. Not only can this mean reversion awareness ease the pain of net worth declines that occur during bear markets, but you can also tweak your investing decisions with this information to help build wealth by buying assets low, and selling higher, based on long term trends. This is logical and may sound overly simplistic, but many investors don’t do it. What keeps individual investors from factoring this reality into their stock market investing decisions? Needing to follow the herd mentality, lack of a plan, recency bias, emotional investing, and lack of knowledge about stock market cycles all contribute to losing money in stocks as I know all too well. Knowing that markets revert to the mean helps you know if the stock market is more likely to go up or down over the next few years. Looking to see how far the market has swung away from the mean, and in which direction, provides valuable and unbiased insights. Read my post How to Not Outlive Your Money for more on this.
2. Excesses in One Direction Will Lead to An Opposite Excess in The Other DirectionAfter bear markets, many investors swear that they’ll never buy stocks again. Everything in the news is about the horrible losses that investors have had. People HATE stocks to an excessive level even though they can be bought very cheaply. Near the end of bull markets, however, everyone LOVES stocks. It feels like the great stock market performance will go on forever even though stocks are overpriced based on history and no longer connected to company earnings. This excessive optimism is called “Irrational Exuberance” and it drives stocks to levels that are no longer supported by the true valuations of the companies in the stock market. Below are some examples of stock market excesses that you may well remember, as I do. Real estate valuations in 2006 were the result clearly excessive lending. Real estate and the financial firms lending money for real estate had to swing in the opposite direction to return to “normal” pricing following the excesses. The tech boom in 2000 was also excessive. The stock index that held the cutting edge technology companies was the Nasdaq. It increased a whopping 85.59% in 1999! This was clearly excessive. The Nasdaq declined over 39% in 2000, then over 21 in 2001, and then over 31% in 2002. Ouch! These downswings were obviously excessive, so in 2003 the Nasdaq swung back up just over 50%! (2.) These are both great examples of exactly what Bob Farrell has explianed so articulately. We can see how logical the return to normal pricing is after these excessive periods. Of course, hindsight is 20 20, but wild excesses such as these make it clear that the stock market (as well as real estate and other asset classes) will need to go up or down to shake out the excesses. Do these wild swings matter for stock market investors? Only you can decide your acceptable risk tolerance level and invest within it. (If you work with a financial advisor, this can be a great conversion to have with him.) Wealth Building Tip – Ironically, the rules of avoiding buying stocks in overvalued markets tend to be forgotten during overvalued markets and remembered when you can buy stocks for dirt cheap.
3. There Are No New Eras — Excesses Are Never Permanent.This investing rule is tied to the popular phrase that fuels many excessive valuations, “This time is different.” Heading into 2000 in the midst of the tech bubble, everyone thought that overall business fundamentals were, in fact, different, because we would all be using new technology that would change the world forever. As it turns out, we are, but even technology company valuations are affected by supply and demand, earnings, by corporate leadership, and by the economy. There are no new eras. While the next time may be a little different, stocks return to valuations that make sense in relation to their financials, and to historical norms.
4. Exponential Rapidly Rising or Falling Markets Usually Go Further Than You Think, But They Do Not Correct by Going SidewaysThe way I state this stock market rule is that trends last longer than you think. I have learned this truth time and time again during trends that are both up, and down. All along bear market declines stock analysts are interviewed in the media explaining how the market will stop dropping soon; yet the downward trend continues longer than expected. And all along the way up, the stock market is climbing a wall of worry, which is another popular saying; then the stock market goes higher and longer than anyone thinks it will. While I have found this rule to be true more often than not, there are exceptions to this stock market rule. The first was the fast bear market that began in October 1987 with the sudden one day steep drop. That bear market ended only three months later. Another breaking of this rule duirng my investing years was the bull market between 2003 and 2007. The average bull market lasts 9.1 years, so a bull market that lasted only a little over 5 years in the mid 2000’s seemed too short following the nasty 2001-2003 bear. (3) Then in March of 2020, the fast bear market was over before it ever settled in. The second part of this stock market rule is that markets don’t correct by going sideways. This implies that markets must go up or down, significantly, to return to the norm, or the mean. Read my related post Investment Strategies Used for High Net Worth Clients with 5 risk management strategies a top financial advisor uses for his clients.
5. The Public Buys the Most at The Top and The Least at The BottomYes, that’s us – the individual investors that Bob Farrell is referencing here. It sounds so easy to buy stocks at low prices and sell them when they are overvalued, especially given the obvious stock market rules you see here from Bob Farrell. Nevertheless, research repeatedly shows that individual investors are the last to buy into the stock market before it goes down. Click here to read my post on Ways to Reduce Investment Risk with buying cheap assets. Wealth Building Tip – Be knowledgable and Zen like with your investing so decisions are guided by logic instead of the emotions of fear and greed.
6. Fear and Greed Are Stronger Than Long-Term ResolveMost people invest based on deep rooted beliefs about money instead of the logic you see in Bob Farrell’s 10 Stock Market Rules or the realiable fundamental and technical data referenced previously. These money beliefs are usually related to childhood or previous mistakes. Those invalid beliefs trigger emotional investing instead of logical investing. Yet, it’s hard to not be fearful about running out of money when you subconsciously operate on fear from past mistakes or depression era parents or grandparents. Plus, as humans, fear is hard wired into our brains from the cave dwelling days; we had to be fearful just to survive. Now, most of us don’t have to be fearful to survive, so we subconsiously invent things to be fearful about to fuel that drive. Running out of money is an excellent target. On the opposite end of the emotional spectrum, it can be hard NOT to get greedy when you see that everyone you know has built wealth from the latest stock bull market. FOMO (fear of missing out) leads investors to get into stock markets near the top of market cycles; the fear of missing out overcomes logical investing. These emotional sabateurs can be overcome by disempowering those limiting beliefs. Learning more about investing, if needed, can also resolve this problem; knowledge fuels better, more logical decisions. Wealth Building Tip – Step back and ask yourself if you are making investment decisions based on logic or on emotions.
7. Markets Are Strongest When They Are Broad and Weakest When They Narrow to A Handful of Blue-Chip NamesTo observe this rule in action, think of FANG stocks, the darlings of the bull market that began in 2009. Facebook, Amazon, Netflix and Google fueled this bull market. These few companies accounted for a very disproportionate share of the overall stock market value in the later stages of this bull market. The speculation and over exuberance around these companies can last longer than anyone expects as explained in rule 4 above, but eventually, they lose steam. Weak markets that are concentrated on a few key stocks are less healthy and are more likely to go down; broad markets are stronger and are thus more likely to continue to increase longer term.
8. Bear Markets Have Three Stages — Sharp Down, Reflexive Rebound and A Drawn-Out Fundamental DowntrendThis stock investing rule will be important to remember during bear markets. Markets tend to fall hard and fast once the institutions begin selling; a quick glance at a stock chart reveals institutional selling volume. Then the markets head back up several times retesting prior levels. This can also be seen on stock charts easily. During this time, there are little up trends inside of the large overall move down. These little up trends can give investors a good opportunity to sell stocks off the lows. Don’t get too caught up in the small trends within the overall larger moves up or down, however, since these are tricky for even the most experienced investors. Instead, focus on the big picture asking if stocks are overvalued, fairly valued or undervalued. Data is easy to get to provide the answer to this question. Image Source – RealInvestmentAdvice.com In the last stage that Bob Farrell refers to here, the prices drop to the point that the numbers make sense to draw buyers back into the markets again. This stage is based more on fundamental analysis. Again, you can see the logic here. Wealth Building Tip – There are 2 types of analysis, fundamental and technical. Technical analysis is based on looking at charts and applying technical indicators. Fundamental, on the other hand, is based on good old fashioned financials related to profits and growth.
9. When All the Experts and Forecasts Agree — Something Else Is Going to HappenIn March of 1998 my mother and I got to take a private tour on the floor of the NYSE (New York Stock Exchange) when we were in NY celebrating her 73rd birthday. (We dined atop the World Trade Center afterward, and my heart swells as I type this, over both the loss of my mother and the many lives lost on September 11, 2001.) The NYSE was giving out Dow 10,000 hats anticipating that the Dow would pass 10,000 for the first time ever that very day. The floor of the exchange was wild, and the excitement was contagious. The seasoned broker who took us around the NYSE floor said to us “If you have money in the stock market, take your profits now. This won’t last much longer.” The market continued its’ uphill climb for 2 more years. Trends last longer than you think, as addressed previously. This also demonstrates, however, that when the experts agree that one thing will happen, something different is going to happen. In the bull market which began in 2009, there were a lot of financial experts saying the market fundamentals were approaching a bear market in early 2013, 2016, 2017 and beyond. The market kept climbing, however. Be aware that many financial advisors are discouraged from focusing on stock market crashes. I admire the financial advisor who confidently and realistically discusses bear markets and overall market valuations. The reality is that bear markets are as sure as death and taxes for stock market investors. Why gloss them over instead of accepting them as a reality, defining your acceptable risk ahead of them, and even taking advantage of them? Here’s what Bob is saying: When all the experts predict the market will go up, the probability is higher that it will go down. When the experts all agree the markets will go down, it’s more likely the market will go up. Here’s my video for How to Know if the Stock Market Will Go Up or Down with the 10 rules addressed in this post.
10. Bull Markets Are More Fun Than Bear MarketsThis is the attitude that prevails in the media, and hence, the general public during bull and bear markets. However, for logic based investors who are prepared for the bear market, with extra cash on the sidelines waiting to be invested at cheaper prices, bear markets can be an opportunity to build wealth. Buying assets cheap can be quite fun and lucrative. Read my related post How to Build Wealth where I write about the cheap asset method of wealth building. For investors who are not invested in bull markets, the frustration of not being in the market can be no fun at all. So, bull markets are fun for those who have created wealth from them but the same can be said for bear markets. Ideally, smart investors will consider market valuations before investing in anything, allowing them to capitalize on both bull and bear markets. Read my related post How Will Stock a Market Crash Affect Me?
How to Know If the Stock Market Will Move Up or Down SummaryYou can see that Bob Farrell’s 10 Market Rules to Remember are all beautifully intertwined into a wealth of investing wisdom. One rule supports the other rules in a way that provides substance and truth. Incorporating these 10 often-overlooked realities into your investing can help you know if the stocks are more likely to go up or down over the next year or two with a higher level of probability. Remember, using probability to your advantage can guide you to build wealth at any age.
- Joe Marwood – https://jbmarwood.com/mean-reversion-trading-strategy/
- First Trust Portfolios LP
The information on this website is for education only and is not to be construed as personal financial advice.