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I posted “Bob Farrell’s 10 rules for investing” a few days ago, and these words of wisdom turned out to be popular reading material.

Given the debate as to as to whether the U.S. stock markets are experiencing a primary (secular) bull market or a rally within a primary bear market, i.e. a so-called cyclical bull market, Farrell’s rule #8 has caused a fair amount of food for thought:

Bear markets have three stages – (1) sharp down, (2) reflexive rebound and (3) a drawn-out fundamental downtrend.

In an attempt to put these stages in perspective, David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates, provided a graphic illustration of Farrell’s three stages, as shown below. (As Rosie’s comments date back to August last year, the graph has just been updated by my colleagues at Plexus Asset Management.)

Click on the image for a larger graph.

Source: Gluskin Sheff & Associates – Lunch with Dave, August 7, 2009 (updated by Plexus Asset Management on April 26, 2010).

Whether stock markets will enter a drawn-out downtrend any time soon remains to be seen, but given the magnitude of the rebound a pullback certainly looks likely. Caution seems to be in order.

Source: Farrell's Rule #8: The Bear Market's 3 Stages