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Yesterday I began outlining some of the principles Jesse Livermore used so successfully to make $1million during the Panic of 1907. $1million doesn’t sound like a lot these days, but of course it must have been worth closer to $100million in today’s terms. Please keep in mind that there are probably a thousand other lessons that one can glean from Livermore’s trading career, and many of his mistakes and shortcomings are probably more instructive.

4.      Probe out weak points. As noted previously, Livermore believed the overall market had the greatest influence on prices. But this didn’t stop him from identifying weaker stocks to short in a bear market, or stronger stocks to go long of in a bull market. Livermore was clearly a believer in relative strength – although his vanity led him to violate this principle on occasions. He looked for unexplained weakness in a stock’s price in the belief that a weak stock would fall further during a general decline.

The main point here is to let price action be your guide. Livermore would sell the general list and let the subsequent price action tell him which stocks acted weaker and should be held for the longer term, and which stocks should be discarded. I suggest it’s tempting fate to short unusually strong stocks, or, conversely, to buy unusually weak stocks. There may be a very good and unpublished reason for the price action. However, don’t use relative strength naively. The odds are much better if you buy/sell as close to a base/top as possible. Entering late in a trend is just asking for trouble. It’s better to follow the crowd at the start of a trend, and better to be a contrarian when the trend is about to end. The trick is in knowing when to do what.

(As an aside, how dodgy was that bounce in Lehman Bros!? I wouldn’t be surprised to find insiders are dumping their stock after that neat piece of manipulation. The gall of Kerrie Cohen to blame short sellers for a 10% decline after LEH cooked the books to pump their stock!)

5.      Don’t listen to wall street chatter. Livermore railed against those that loved to give and receive tips. In his opinion traders who engaged in tips were ‘like drunkards’, their “hope bandaged by [their] unwillingness to do any thinking”. Similarly, he distrusted the financial press, understanding full well how easily it could be manipulated. Finally, he was usually fiercely independent of his peers (with a couple exceptions, such as cotton trader, Percy Thomas). Full timers are just as susceptible to rumor mongering as amateurs.

Nicholas Darvas also pointed out the dangers of listening to the opinions of others. Better to develop your own system, thoroughly back test and understand it, and study your tradecraft until you know enough to see through the BS that others are constantly peddling. I’m constantly amazed by the delusional market commentary I read in some newsletters. A professional investor here in Oz was embarrassed by several bad calls he made last year, and, having suffered significant losses as our market crashed, he’s now exacerbated his foolishness by calling the market bottom. A brave call given that our average bear markets last 370 days, and this one is only147 days old so far. As Livermore says about the 1907 bear,

“It was curious how, after suffering tremendous losses from a break of fifteen or twenty points, people who were still hanging on welcomed a three-point rally and were certain the bottom had been reached and complete recovery begun.”

Of course it’s fine to have a theory about when and why the market should stabilize. But I’ve noticed already how many ‘market experts’ are calling an end to the bear market, more out of hope than for any other reason. They may be right. But a trusty coin is usually a more reliable tipster. Better to do your own thinking and research, and constantly look for evidence that you’re wrong.

For what it’s worth (not much as I’ve outlined above), my moistened finger in the wind call is that we’re in for further falls. I believe we’re in a bear market, and bear markets have typically declined by at least 30% and lasted for at least nine months. This one could be a lot worse for the reasons outlined by Roubini and Jim Grant. Check out Grant especially.

In any case, I’m likely to remain bearish until the Coppock (plotted in green below) crosses below zero and then turns up. This has been a very reliable – although late – indicator for the S&P500 for determining the start of a bull market. Since 1960, there’s been only one false signal (circled in red).

In my last post I suggested that we’re in a bear market and that we would be wise to position ourselves accordingly. To this end I suggested that the account of Jesse Livermore’s experiences during the 1907 Panic could provide us with some useful tips.

At the outset I should say that Livermore’s approach is obviously not for everyone, probably not for very many at all. Nor should we receive his lessons without a dozen caveats attached. I certainly wouldn’t recommend anyone employ his approach to leverage which caused his account to fluctuate wildly – at times he made staggering fortunes; on at least four occasions he ignored his own rules on risk and went bust.

I’m sure if Livermore were alive today he would freely admit he was hardly a perfect role model; not in life or in trading. Indeed, he appeared painfully aware of his mistakes. In ‘Reminiscences of a Stock Operator’ Lefevre writes,

“…if a man is both wise and lucky, he will not make the same mistake twice. But he will make any one of the ten thousand brothers or cousins of the original. The Mistake family is so large that there is always one of them around when you want to see what you can do in the fool-play line.”

I can certainly relate to that.

Nevertheless, I’d rather not dwell on the few contradictions evident in his method, or the inconsistencies in his application. Livermore had a streak of genius about him which, if we distill it out from his many flaws, provides us with a timeless guide for trading the markets. Below I pick out some of the points I believe are most relevant to us at present. (Btw, I’m aware that Richard Smitten and others have also written on Livermore’s approach. I haven’t read their work and can’t comment on what they say).

1.      Study basic conditions. A critical stage of Livermore’s development was when he moved away from the strictly technical system and began to study ‘basic conditions’. By this he meant he began to study the fundamentals of the broader economy and individual sectors. This allowed him to determine the broader trend in the markets and economy, formulate a plan and position himself so that the odds would be in his favor.

The application for us today should be obvious. We need to determine whether the market is bullish or bearish, identify the fundamental factors feeding into this, and speculate on how long these conditions are likely to continue. In 1907, Livermore noticed that money was getting tight, that the bull market had been in place for some time and that the odds of a bear market outweighed the odds of the bull market continuing. Like many perma-bears, however, Livermore was too early with his call. And his risk control at that time was particularly poor, sending him bust. However, he obtained further credit and persisted. When the crash finally came, he cleaned up and declared himself to be “permanently out of the gambler class” (a debatable point).

2.      Be bearish in a bear market, bullish in a bull market. Livermore understood that the prevailing market conditions were all important. In his opinion the big money was in the big swing, and playing for smaller fluctuations was a low probability game. Moreover, Livermore agreed with old Partridge that losing one’s position was a great risk. If a trader is confident that the bull/bear market will continue, it’s better to ride out the counter-trend rallies and play for the big swing. Of course this is the essence of trend trading. Livermore didn’t follow his rule on this religiously, however, but invariably lost money when he didn’t.

This point is clearly related to the first. There’s no point identifying the prevailing market conditions and then continuing as though it doesn’t matter. In a bear market, either get out so you don’t get hurt, or go short, or hedge, or switch to a value system, etc, depending on your trade plan. Some well-known traders have said that roughly 60% of a stock’s action is determined by the market, 30% by the sector and the remaining 10% by the stock’s fundamentals. These stats are clearly not easy to verify, but intuitively they seem right for the majority of stocks. How many stocks are making new highs at present? But as Livermore said,

“The average man doesn’t wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing… He doesn’t even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

*Note: For those wondering why my Covestor account shows only longs (my long-term holdings that are yet to be stopped out), it’s because my broker doesn’t allow short selling, and the antiquated Australian system makes short selling difficult and expensive for most people. Instead I go short in a separate account using CFDs. Covestor doesn’t yet allow CFDs, but hopefully that will change soon. Sigh, so many restrictions.

Tomorrow: part 2.

A couple of market commentators (eg. Chris Mayer) have drawn parallels between today’s credit crunch and the Panic of 1907. There are certainly a number of similarities: in 1907 speculation was rampant and credit expansion out of control. New, highly leveraged investment vehicles (the Trusts) embraced the easy money conditions and employed little in the way of risk control. At first they profited greatly. But, as always, market conditions changed, money became tight, and the credit bubble burst. Then, as now, lending collapsed and the runs on the banks and trusts began.

Of course there is at least one notable difference between 1907 and now: in 1907 there was no Fed to ‘rescue’ the financial system. Back then the big private players, led by JP Morgan, organized a rescue of the less insolvent firms, and restored confidence to the system. They had rather more clout back then. Today, in a rather sad echo of 1907, the Fed arranges a convoluted deal with JP Morgan to take over Bear Stearns. I agree with Hussman that this deal is more likely to enrich JP Morgan than save us from a market crash.

Interestingly, the wider economy in 1907 suffered only short-term effects from the numerous bank failures and the 50% fall in the market. Nevertheless, the Fed was established in 1913 to ensure there would be no repeat. Ironically, 16 years later the Fed would exacerbate a market bubble and mishandle the subsequent collapse to such an extent that the great depression would result. This last point has been hotly debated over the years, but mainstream economists generally agree that the Fed’s contraction of the money supply was chiefly to blame for the mess from 1929 onwards. Ironically, again, chairman Bernanke shares this view, yet believes this time the Fed will be our savior. Time will tell I guess, but I’m skeptical.

As speculators (or investors if the semantic difference matters to you) I think we should treat this history lesson with more than mere idle curiosity, especially if we believe the Fed cannot prevent the market from falling further (here I defer to Hussman, Mauldin and Mish who argue the case for a secular bear market very well). I don’t believe we should simply hunker down and hope to ride this thing out. There are ways to profit under almost any conditions. And luckily for us Edwin Lefevre’s account of Jesse Livermore’s 1907 coup provides us with an excellent guide. But as this post is already overlong, I’ll leave that till tomorrow.

Another shorting opportunity. ATI looks like it will test resistance at 85. If/when it fails, look to short with a downside target of around $30. Targets are dodgy to say the least. So look to take profits following sharp sell-offs. Or better yet, trail your stop and hold for as long as possible. Then look to take profits when you believe the market is set for a rally, but not until late in the year.

not sure how to designate a short on my watchlist. Anyhoo, AIG has formed a massive 9-year top. there's plenty of overhead supply if the price continues rising. suggest a limit entry at 46.99 with a downside target of around 10. suggest taking profits following very sharp falls however. Stop should be set no closer than 52.31

Well, I don't know. Markets around the world are plunging. BSC goes bankrupt. The Fed is desperately trying to slap a band aid on the problem. And yet the S&P rallies! Looks like I'll have to wait a bit longer for my shorts to come good.

I'm following a fascinating debate on deflation vs inflation between Mish (http://globaleconomicanalysis.blogspot.com/2008/03/now-presenting-deflation.html) and Blumen among others. Either way the Fed has a huge problem on its hands. Will be very interesting to see how the markets  react to the next rate cut. Will 75 or 100 basis points be enough? Will ZIRP be enough? Will the dollar be the next carry trade as Chuck Butler suggests is possible?

Thankfully the USD/JPY did bounce a bit, and thankfully it was weak. I'm looking for a small consolidation just under 100 which will give me a chance to add to my shorts and keep my risk on the new positions low.

Well it's 11:43 Sydney time and the All Ords is down 130 points! What's more, the Yen is trading at 97 (yes, a dollar bounce is probably coming but I'm enjoying it while it lasts) and gold is $1020! This bodes ill for those carry traders and US bulls. Will be very interesting to see what happens on the US markets when they open in a few hours.

My US shorts, believe it or not, have been languishing since January. My timing was dreadful, and I've been stopped out for steep losses on TS, BCO, and ERF. However, I'm still alive on TYC, CBSH, FRT, HIG, MKL, OSK, SUN, TEG, AXP, BBV, and EEA. If the markets tank this week, as they should given the news on BearStearns, my trades should all come good. JPMorgan's buyout may encourage some diehards, but surely only for a short while. I guess we'll see. In the meantime, I'm just loving the volatility and especially the ride on Gold and the Yen. Just hoping I can walk away with the profits at some point in the future before it all comes crashing down.

So far today my Oz longs are at breakeven despite the big drop. My gold stocks are counteracting the drops in my other longs. CGX, especially, is holding up. And, given its relative weighting in my portfolio, its action has a disproportionate effect on my long position.

Looking forward to the days when Covestor incorporates CFDs and other instruments. Hopefully they'll reconsider the merging of accounts as well.

The Delusion Continues