Stock Market Rules
If there is one lesson I have learned, in my nearly thirty years of managing investment portfolios, it is that there are no foolproof rules for success in the stock market. Despite the claims of thousands of books, newsletters, and self-proclaimed market guru’s, there is no magic formula. About the best that can be said is that there are certain patterns in the market that seem to be repeated with uncanny regularity. Having knowledge of these patterns can help investors make more informed decisions.
Many stock market observers have noted a variety of these “market tendencies”, but those described by Bob Farrell, long-time chief stock market analyst at a major wall street firm, are very insightful. Although Farrell retired in 1992, his “10 Market Rules to Remember” have remained relevant to market participants. They are summarized here, as reprinted by Seeking Alpha.
1. Markets revert to the mean over time.
When stocks go too far in one direction, they usually come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.
2. Excesses in one direction usually lead to excesses in the opposite direction.
Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction.
3. There are no “new eras” – excesses are never permanent.
Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots on the downside. As the fever builds in an overheated market, a chorus of “this time is different” will be heard. And of course, it - human nature – is never different.
4. Exponentially rising or falling markets usually go further than you think, but they do not correct by going sideways.
Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction, at some point.
5. The public usually buys the most at the top and the least at the bottom.
Follow the sentiment indicators to measure the mood of individual investors.
6. Fear and greed are stronger than long-term resolve.
Investors can be their own worst enemy, particularly when emotions take hold.
7. Markets are strongest when they are broad and weakest when they narrow to a handful of stocks.
Broad momentum is hard to stop. Watch for when momentum channels into a small number of stocks.
8. Bear markets have three stages – sharp down, reflexive rebound, and a drawn-out fundamental downtrend.
9. When all the experts and forecasts agree – something else is likely to happen.
10. Bull markets are more fun than bear markets.
So, which of Farrell’s rules should we be most concerned about now? The rule with the most relevance to the current market environment appears to be #8. If bear markets have three stages, which stage are we currently in? We have certainly had the sharp down phase, followed by a reflexive rebound off the March 2009 lows. Will we now enter a drawn-out fundamental downtrend? No one knows for sure, but history tells us that there is some reason to be more cautious now, with the market up nearly 50% from the bottom. Short-term profit taking could lead to a significant pullback. Also supporting this view is #7. Trading volume has slowed and the market has narrowed, with the most significant gains coming from lower quality stocks that had been hit the hardest in the downturn. Narrowing breadth and low volume are not usually signs of strength.
Investors should never depend solely on rules or historical precedents. But these are just one more piece of the puzzle that should be taken into consideration, along with other fundamental factors, when investing in stocks.
Friday, August 21, 2009
Tuesday, February 24, 2009
Mark-to-Market Accounting
Following, is an excellent article from Forbes about the problems with mark-to-market accounting:
Why Mark-To-Market Accounting Rules Must Die
Brian S. Wesbury and Robert Stein 02.24.09, 12:01 AM ET
We have been accused of beating a dead horse when it comes to our support for either suspension of, or targeted relief from, market-to-market accounting.
And we suppose after writing thousands of words, producing videos and giving speeches about the issue, some might be tempted to let it go. But we can't do that, especially when the government continues to spend trillions of dollars and is coming very close to bank nationalization.
This is a real shame. Suspending mark-to-market accounting could fix major problems at no cost. Unfortunately, many people dismiss this issue without really understanding its impact on the economy.
We are economists, not accountants or bank analysts. We really don't think a debate about how big the housing bubble was, or whether a certain bank is viable or not, is worthwhile when it comes to accounting rules. That misses the point. Mark-to-market accounting rules affect the economy and amplify financial market problems.
The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.
Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
Because these accounting rules force banks to write off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value, based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.
And this affects growth. By wiping out capital, so-called "fair value" accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed, and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It's a vicious downward spiral.
In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the U.S. cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed, even though roughly 3,000 banks failed, without creating an economic catastrophe.
In Japan, during the 1990s, the government allowed banks to operate without ever recognizing bad loans, which certainly bought time. However, Japan increased taxes and ran an excessively tight monetary policy, which undermined growth. This created an economic disaster. The real problem with Japan was not zombie banks; it was that there was no growth. After all, foreign banks were allowed to lend in Japan and were not in bad shape like the Japanese banks. They stayed away from Japan because the economy was not vibrant.
A final example: In the 1930s, because mark-to-market accounting existed, we limited the amount of time available to fix problems. At the same time, the U.S. raised taxes, increased spending and economic interference, and became protectionist. This hurt growth. The reason the Great Depression was so bad is that we took away time and growth.
Anyone worried about repeating the errors of Japan in the 1990s or the U.S. in the 1930s should focus on the policies that impeded recovery. Suspending mark-to-market accounting is a cost-free way to buy time. It does not allow banks to sweep bad loans under the rug. Bad loans are still bad loans, and banks cannot hide from them. Not suspending it, while at the same time interfering in the economy with massive stimulus and bank nationalization, is a recipe to undermine both time and growth and therefore hurt the economy even more.
Brian S. Wesbury is chief economist, and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill. They write a weekly column for Forbes.
Why Mark-To-Market Accounting Rules Must Die
Brian S. Wesbury and Robert Stein 02.24.09, 12:01 AM ET
We have been accused of beating a dead horse when it comes to our support for either suspension of, or targeted relief from, market-to-market accounting.
And we suppose after writing thousands of words, producing videos and giving speeches about the issue, some might be tempted to let it go. But we can't do that, especially when the government continues to spend trillions of dollars and is coming very close to bank nationalization.
This is a real shame. Suspending mark-to-market accounting could fix major problems at no cost. Unfortunately, many people dismiss this issue without really understanding its impact on the economy.
We are economists, not accountants or bank analysts. We really don't think a debate about how big the housing bubble was, or whether a certain bank is viable or not, is worthwhile when it comes to accounting rules. That misses the point. Mark-to-market accounting rules affect the economy and amplify financial market problems.
The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.
Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
Because these accounting rules force banks to write off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value, based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.
And this affects growth. By wiping out capital, so-called "fair value" accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed, and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It's a vicious downward spiral.
In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the U.S. cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed, even though roughly 3,000 banks failed, without creating an economic catastrophe.
In Japan, during the 1990s, the government allowed banks to operate without ever recognizing bad loans, which certainly bought time. However, Japan increased taxes and ran an excessively tight monetary policy, which undermined growth. This created an economic disaster. The real problem with Japan was not zombie banks; it was that there was no growth. After all, foreign banks were allowed to lend in Japan and were not in bad shape like the Japanese banks. They stayed away from Japan because the economy was not vibrant.
A final example: In the 1930s, because mark-to-market accounting existed, we limited the amount of time available to fix problems. At the same time, the U.S. raised taxes, increased spending and economic interference, and became protectionist. This hurt growth. The reason the Great Depression was so bad is that we took away time and growth.
Anyone worried about repeating the errors of Japan in the 1990s or the U.S. in the 1930s should focus on the policies that impeded recovery. Suspending mark-to-market accounting is a cost-free way to buy time. It does not allow banks to sweep bad loans under the rug. Bad loans are still bad loans, and banks cannot hide from them. Not suspending it, while at the same time interfering in the economy with massive stimulus and bank nationalization, is a recipe to undermine both time and growth and therefore hurt the economy even more.
Brian S. Wesbury is chief economist, and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill. They write a weekly column for Forbes.
Friday, February 20, 2009
Nationalization Nervousness
Today's -1%+ market decline was atttibuted to increased fear of bank nationalizations. Will shareholders of America's banks wake up tomorrow to find their shares completely worthless because they have been seized by the government? I think not. As bad as the credit crisis has become, nationalization is probably not the best answer. There is a way to help stem the crisis without resorting to such draconian measures. A temporary suspension of fair value accounting rules would buy time for the banks to sort out some of their problems. If assets do not have to be immediately written down to levels that represent a worst case scenario, the banks would not have to raise capital in the current environment. This would allow some breathing room for the banks and time for the economy to improve. Opponents of the suspension of FAS 157 point to the need for transparency. I for one, would rather preserve capitalism than transparancy at this particular time.
Friday, February 6, 2009
Optimism Returns
After a terrible employment report this morning, the stock market has mounted a strong rally. Near the close, the Dow is up 239 points or nearly 3%. Financial stocks have led the market up today. Earlier, Bank of America's CEO, Ken Lewis, made strong comments against nationalization of banks and purchased another block of BAC stock. This seems to have given some bank shareholders hope that their stocks will still have some value left after the crisis subsides.
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