Sunday, March 25, 2012

Jesse Lauriston Livermore - Legendary Market Trader (1)


Ben Graham and his student, Warren Buffett, are considered icons of fundamental analysis and value investing.  Market timers and momentum traders also have their hero:  Jesse Lauriston Livermore, who was known early in his career as the "Boy Plunger" and later on as the "Great Bear of Wall Street." 

Livermore was born in Massachusetts in 1877.  He started his career at the age of 14 in Boston posting stock quotes for a brokerage firm.  He made his first money trading in bucket shops.  A bucket shop was a form of stock market casino in which the patrons could make bets on stocks with little money down and large margins (borrowed money).  The shop did not really buy or sell the stocks picked by the customers, but rather paid off winning stock picks (just like a horse track).

Livermore made and lost millions during his career.  Having succeeded by short selling during the stock market panic of 1907, he recognized the signs of pending decline in 1929.  He again shorted the market successfully during the October,1929 crash.  It is said that he had a net worth of $100 million dollars (1929 dollars) after the most famous market crash in American history.

The author and journalist, Edwin Lefevre, is credited with writing the ever popular book, Reminiscences of a Stock Operator, first published in 1923.  It is believed that he collaborated with Jesse Livermore in writing the book, which is a thinly veiled biography of the famous trader, recounting many of his triumphs and losses.  Most importantly, the author provides detailed descriptions and explanations of his trading strategies in a first person, conversational, writing style.  Livermore later claimed to have written the book with Lefevre serving as editor.  In any event, Livermore also wrote a book under his own name, How to Trade Stocks, which was published shortly before his death in 1940.  Both books remain in print today.

Mr. Lefevre, speaking as Livermore, recounted several general rules about the market and traders.  In discussing the market, he wrote as follows:

Another lesson I learned early is that there is nothing new in Wall Street.  There can't be because speculation is as old as the hills.  Whatever happens in the stock market today has happened before and will happen again.

Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street.  When you read contemporary accounts of booms and panics, the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday.  The game does not change and neither does human nature.

Weapons change, but strategy remains strategy, on the New York Stock Exchange as on the battlefield.  I think the clearest summing up of the whole thing was expressed by Thomas F. Woodlock when he declared:  "The principles of successful stock speculation are based on the supposition that people will continue in the future to make the mistakes that they have made in the past." 

The lesson to take away from this discussion is that the individual investor or trader must be very careful when he or she is told, "This time, it's different."  The person's inner response should be that the situation may appear different, but it is really the same old wolf disguised in a new sheepskin.

We will look at more lessons from Reminiscences in the next blog.

Excerpts from Reminiscences of a Stock Operator, Edwin Lefevre, 1923, republished by John Wiley & Sons, Inc. in the Wiley Investment Classics series

Comments are always welcome.

Monday, March 19, 2012

Looking For Action - Momentum Trading


There is a significant amount of scientific research and literature dealing with birds of prey, such as eagles, hawks and falcons, and how they hunt.  The raptors' vision far exceeds that of humans.  The bird perches in a tree or other elevated location and searches the surrounding area (up to a mile away) for small mammals.  What attracts the bird's attention is movement.  This explains why rabbits can remain still for such long periods of time.  Movement attracts the hunter's attention.  The same thing holds true for momentum traders.

Momentum trading is based on two concepts.

The first is that investors are slow to react to news about a company or its stock.  Unexpected price announcements or other surprising company news (whether good or bad) may trigger a move in the company's stock which will continue for a period of time after the announcement as investors analyze the news and decide how to react.  The momentum trader looks to quickly jump into the stock early in the move and sell out of the stock with a profit shortly thereafter.  Momentum trading based on announcements has a time horizon measured in hours or, at most, a day or two.  Because the stock movement is usually small, in relative terms, many momentum traders use margin (borrowed money) to increase the amount of profit he or she hopes to gain.

The second basis for momentum trading is the old rule, "The trend is your friend."  The trader looks for stocks with a large degree of "relative strength."  The trader may compare the stock's current velocity of price change to its average rate of change over the past few months.  If the stock has been moving in a direction at a price change rate of $1 per week and is now trading at a rate of $5 per week, it would look like a candidate for a momentum trade.  It is also possible to compare a stock's rate of price change to the average rate for other stocks in its industry or in the overall market.  Similarly, the momentum trader may look for stocks with unusually high trading volume.  A stock which normally trades 10,000 shares a day and is now trading 100,000 shares a day will attract the attention of the momentum trader.  These traders may also look for a chart indicator showing a point of inflection, i.e., the point at which the stock's trading trend will reverse.  Large volumes following such a change of direction would be attractive to momentum traders.  As we learned in an earlier blog, this point of inflection is best demonstrated by the head and shoulders technical indicator.

Successful momentum traders have two characteristics.  First, they must have the time to devote to the constant monitoring of his or her stock positions throughout the day.  Second, they must be ready to trade out of a stock at a loss very quickly if the movement is going against them.  The big profit on one trade is supposed to make up for the small losses of other trades.  Momentum trading, therefore, is a strategy for professionals who are in the market on a daily basis and are willing to suffer any number of small losses as a "cost of doing business."  It is not a strategy for the "part time" amateur.  If you are interested in learning more about momentum trading, here is a link to an in depth article about it.  I suspect there may be mutual funds using momentum trading as their primary strategy.

In the next blog we will learn about one of the most famous of these traders, Jesse L. Livermore, who made and lost millions on Wall Street during the early decades of the twentieth century.

Comments are always welcome.

Monday, March 12, 2012

Is Timing As Important On Wall Street As It Is In Life? (2)


Before we get into this blog, I must apologize for a mistake in the last one.  I erroneously mentioned the Russell 5000 Index.  It is actually the Russell 2000 Index.  I confused it with the Wilshire 5000 Index.  Sorry for that.  Now we will wrap up the topic of market timing.

The American author Mark Twain is best known for his many books and essays on life as he saw it.  He also had some ideas about the stock market.  Here is one of his observations on investing:

October.  This is one of the peculiarly dangerous months to speculate in stocks in.  The others are July, January, September, April, November, May, March, June, December, August and February.*

As I have said in the past, if you look long and hard enough, you will find some degree of correlation between all sorts of essentially unrelated events.  Based on a study for the years between 1949 and 1975, some analysts feel that there is a connection between the behavior of the market in January and the rest of that year.  The old saying is, "As January goes, so goes the year."  Interestingly, in the years prior to 1949, January's action was accurately predictive only 50% of the time, equivalent to a coin toss.  I suspect the study's time period stopped in 1975 for the same reason.

Some believe that politics may have an effect on the markets.  Several studies over the years have concluded that Wall Street has greater gains under Democratic presidents than under Republicans.  In a recent article in the Wall Street Journal, it was reported that the Dow Jones Industrial Average has recorded a 7.8% yearly gain under Democratic presidents and only a 3% gain per year under Republicans since 1900.  A 9.6% average annual gain was reported during the terms of every Democratic president faced with a Republican Congress.

Two of the more lighthearted market timing predictors are the Super Bowl Effect and the Hemline Index.  The belief regarding the Super Bowl Effect is that if an NFL team wins the Super Bowl, the market will do well that year.  If an AFL team wins, the market is in for a decline.  I must assume someone with a lot of time to waste discovered this relationship.  The Hemline Index stands for the proposition that the length of women's dresses and skirts is an indicator of the market.  If the skirts are rising, so too will the market.  Conversely, if skirts are lengthening and heading to the ankles, a market decline is in the offing.  Not to put too fine a point on this one, but there is a limit as to how high a woman's skirt can rise, i.e., how short it can be and still be worn in public and probably the same holds true for the market.  Like dresses, markets can not rise forever.  At best, you might be able to say that the hemlines rise during good times when people are happy, optimistic and eager to invest.  They drop when the mood of the people becomes somber (because markets are declining?).  I would strongly advise against betting your life savings on either of these indices.

Norman G. Fosback, in his book Stock Market Logic, A Sophisticated Approach to Profits on Wall Street, probably summed up timing and cycles best when he wrote: 

Most cycles are without doubt figments of the imagination.  Nevertheless, strange things exist in the universe, and the ultimate resolution of the truth of cyclic phenomena must await further study.  In the meantime, if cycles have a utility, it is in reminding us that "This, too, shall pass;" that no bull market or bear market lasts forever. **

I will end this blog on timing the way I started it; with another quote from Mark Twain:

There are two times in a man's life when he should not speculate: when he can't afford it, and when he can.***

 We will look at the other offspring of technical analysis, momentum trading, in the next blog.

* Excerpt from Pudd'nhead Wilson, Mark Twain, 1894

** Excerpt from Stock Market Logic, A Sophisticated Approach to Profits on Wall Street, Norman G. Fosback, copyright 1976, 1993, The Institute for Econometric Research, page 168

*** Excerpt from Following the Equator, Mark Twain, 1897

Comments are always welcome.

Monday, March 5, 2012

Is Timing As Important On Wall Street As It Is In Life? (1)


The mantra of market timing traders is, "Buy low, sell high."  Essentially, market timing is asset allocation, i.e., switching your investment funds in and out of equities and interest bearing securities (corporate or government debt instruments) to avoid market declines and capture market tops.  When the market has peaked, you sell your stocks and buy bonds.  When the market has bottomed out, you sell the bonds and reinvest in stocks.  One market researcher studied the stock market from 1946 through 1991.  He calculated that the annual overall market return for this 45 year period was 11.2 percent.  His research showed that if an investor had been able to timely move his funds out of the stock market and avoid the period's 50 worst months and then get back in (again on a timely basis), the annual return on his funds would have been 19 percent, an increase which would certainly have warranted the effort.

If it were only that easy.  How does a trader decide that the bad times are coming?  More importantly, how does he or she decide it's time to jump back into stocks?

Technical analysts look at volumes and prices of stocks they follow.  Market timers look at the same statistics, but on a market wide basis.  If the volume of the overall market is heavy and price advances rapid across the board, the timer looks to pick the top at which he or she sells all equity positions ahead of the anticipated decline.  Conversely, when volumes are thin and prices appear totally depressed, the timer sells his or her bonds and moves back into the market, buying equities in anticipation of the upward swing of prices.  The market timer might trade index funds representing the S&P 500 or the Russell 5000 Indexes.  There are as many indexes as there are market groups.  There are bond funds of various types to use when it appears to be time to leave equities.  I am sure that timers have other strategies as well.  Indeed, there are market timing mutual funds, run by money managers who specialize in this form of trading.

Both investors and traders keep their eye on the relationship between prevailing interest rates for debt instruments and the anticipated returns of equities.  If bonds offer a return higher than that of equities by a substantial amount, an individual may conclude that now is the time to load up on debt securities.  Professor Burton G.Malkiel described this tension between debt and equities as follows:

The stock market, no matter how much it may think so, does not exist as a world unto itself.   Investors should consider how much profit they can obtain elsewhere.  Interest rates, if they are high enough, offer a stable, profitable alternative to the stock market.  Consider periods such as the early 1980s when yields on prime quality corporate bonds soared to close to 15 percent.  Long-term bonds of somewhat lower quality were being offered at even higher interest rates.  The expected returns from stock prices had trouble matching these bond rates; money flowed into bonds while stock prices fell sharply.  Finally, stock prices reached such a low level that a sufficient number of investors were attracted to stem the decline.  Again, in 1987, interest rates rose substantially, preceding the great stock market crash of October 19.  To put it another way, to attract investors from high-yielding bonds, stocks must offer bargain-basement prices.

A rational investor should be willing to pay a higher price for a share, other things being equal, the lower are interest rates.*

The market timer has two negatives to overcome with this strategy.  Brokerage commissions and fees can put a drag on returns if there is a good deal of trading, and this activity generates income taxes, both of which need to be accounted for when calculating the true return on the investments.There are also some non-technical (and amusing) timing strategies.  We will look at some of them in the next blog.

* The material from A Random Walk Down Wall Street by Burton G. Malkiel, copyright 1999, 1996, 1990, 1985, 1981, 1975, 1973 by W.W. Norton & Company, Inc is used with permission of W.W. Norton & Company, Inc.

Comments are always welcome.