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Playing by the rules

I was pleased to be reminded of a set of rules that are all to easy to forget when markets prove as tricky as they have been. Originally laid down by Merrill Lynch’s Bob Farrell and styled as Ten Market Rules to Remember, they were designed as a guide to wise investing. Recently, the economics team at Merrill revisited these rules with the intention of applying them to current market circumstances.

Sadly, there is no rule that encompassed what the consequences of your established and revered employer being taken over by another financial institution might be but the conclusions they reached, admittedly just ahead of the collapse of Lehman Brothers and the rescue of AIG, made interesting reading.

Rule one in many ways demonstrates totally the wisdom of this handy set of guidelines. Markets tend to return to the mean over time. In other words, just because the valuation applied to shares, as an example, has become more – or less – extravagant does not mean it will always remain so. The economists went back over time and examined all manner of markets, including housing, and could not find a single example of failure to revert to mean.

Rule two follows neatly from this – excesses in one direction will lead to an opposite excess in the other direction. The example they chose was oil and they reached the conclusion that the stage was being set for an opposite excess towards lower prices.

Given the price then was still above $100 a barrel, they appeared to have got the short-term timing right. The dollar, too, could be said to be correcting an excess. The interesting question is whether credit markets have yet compensated for their excesses.

Rule three – excesses are never permanent – is one some will take issue with but much “new era” thinking, believing that we really will run out of oil, for example, is proved wrong fairly swiftly. Perhaps more relevant currently is the fourth rule – exponentially rapidly rising or falling markets usually go further than you think but they do not correct by going sideways. This is not a comforting thought although it reminds me that just two weeks ago I was warning investors that trying to spot the turn in the market was impossible.

At a recent conference, one of the speakers alluded to fear and greed among investors – or behavioural finance as he called it. Human nature being what it is, investors are driven to observing Bob Farrell’s fifth rule – the public buys the most at the top, the least at the bottom. While this might appear a statement of the obvious, it is important. The reality is that people find it hard to sell assets that are rising or buy those that have performed poorly, regardless of valuation.

Thus, rule six – fear and greed are stronger than long-term resolve – reflects the reality of how investors behave. It is all too easy to see what you should have done with the benefit of hindsight but implementing a sensible strategy in the face of compelling momentum can be very hard.

Rule seven – markets are strongest when they are broad and weakest when they narrow – has been borne out by the behaviour of commodities recently. As to rule eight, which cites that bear markets have three stages, sharp down, reflexive rebound and a drawn-out fundamental downtrend, my hope is that we are well into the third stage.

Rules nine and 10 resonate with me in no small measure. When experts and forecasts agree, something else is going to happen – has been proved right so often that I worry when other commentators agree with me. The 10th rule – bull markets are more fun than bear markets – goes without saying. While there are investors (or speculators, depending on your point of view) that prosper in bear markets, I do not count myself one of them.

Brian Tora (brian.tora@centaur.co.uk) is principal of the Tora Partnership

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Over the last few years, the prices of most asset classes have risen strongly and a major factor behind this has been the availability of cheap money. This continued to be the case until about a year ago. Almost all assets rose whereas their performance would normally have diverged to a greater extent. This process was driven by strong flows of liquidity into markets.

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