Why It’s So Important For A Stock Operator To ‘Know Thyself’

“A stock operator has to fight a lot of expensive enemies within himself.” -Jesse Livermore

Over the weekend I came across a brief interview with Bill Gross published in the New York Times, in which he says, “There was an old dude, Jesse Livermore, who wrote a great book that said the most important thing in investing was to know yourself — your weaknesses, your flaws and your strengths.”

I thought about that for quite a while after reading it. I read Reminiscences of a Stock Operator a long time ago and didn’t quite remember the book the way Gross did. But thinking about the Gross quote, I realized that all of my greatest trades have been the result of taking advantage of my greatest natural strengths. All of my greatest mistakes have been the result of not recognizing quickly enough the natural weakness that was at the root of the losing trade.

I decided to actually put pen to paper to consciously explore what I believe are my natural strengths and weaknesses. This, to become more acutely aware of them in order to better actively take advantage of my natural strengths and avoid or ameliorate my natural weaknesses.

Here’s what I believe are my natural strengths:

  1. A willingness to go against the herd. More so, a natural skepticism toward what’s popular.
  2. An ability to see points of view or arguments on their merits, without logical biases.
  3. Confidence in my own research and abilities.
  4. A natural inclination towards unloved and overlooked opportunities.
  5. A deep passion to constantly learn and improve.

Here’s what I believe are my natural weaknesses:

  1. I have a hard time staying with there trend, especially once it becomes popular.
  2. At times I can be too skeptical or focus too much on worst-case scenarios.
  3. I can be overconfident even when the market tells me I’m wrong.
  4. I tend to look for confirmation of my point of view rather than opposing views.
  5. At times I seem to care more about being right than making money.

Over the years I’ve managed to address many of these weaknesses. There isn’t any trader who is even mildly profitable who hasn’t been able to do this at least to some degree. But writing them down, putting them on paper somehow helps to compartmentalize them and, more importantly, address them directly.

I realized that consciously addressing them by coming up with tactics to ameliorate them might give me the opportunity to turn my natural weaknesses into developed strengths (as opposed to natural ones). This is something I’ve also done subconsciously to an extent but to do it consciously and methodically could potentially magnify the benefits.

Taking each natural weakness one by one:

  1. Hard time staying with the trend – Modify my sell discipline to take advantage of the long-term trend. So long as there is no compelling reason to sell we will continue to hold until the long-term trend changes.
  2. Too skeptical – Don’t let macro worries get in the way of good micro opportunities. It’s okay to ‘worry top down’ so long as you continue to ‘invest bottom up.’
  3. Overconfidence – Confidence is great and even necessary but humility is just as important. You must respect the market even if you don’t defer to it.
  4. Confirmation bias – The greatest investors regularly seek to understand the other side of a trade even better than those taking it. Spend far more time studying the opposing view.
  5. Being right versus making money – Regularly admit you’re wrong even in the smallest cases. Make it a habit so that acknowledging a mistake and moving on can happen very quickly.

These natural weaknesses are precisely the “expensive enemies” Livermore wrote about. But by ‘keeping your friends (natural strengths) close and your enemies (natural weaknesses) closer,’ in this way I believe a stock operator gives himself the best opportunity to find success in the markets in his own unique way.


Welcome To The Everything Bubble

This post first appeared on The Felder Report Premium on May 2nd:

Everything is overvalued. Stocks are extremely overvalued. An incredible amount of bonds have negative yields; how much more overvalued can they get? Investment-grade and high-yield credit spreads are near all-time lows on top of some of the lowest rates we’ve ever seen! Prices for high-end real estate, art and other collectibles are off the chart. I’ve thought of calling this the “everything bubble,” because looking at each one on its own (outside of small cap stocks which are largely obscured from view) there’s no obvious bubble similar to the dotcom or real estate bubbles. But taken together we’ve never seen anything like this ever before.

I believe the real problem lies in the growth of “price-insensitive buyers,” as GMO recently labeled them. I’ve also called them “value agnostic.” Ultimately, there’s a growing class of investors (though I believe they don’t deserve that term) who are buying assets like stocks and bonds regardless of their valuations. They will buy stocks to the moon simply because their methodology dictates they do so. I’m referring mainly to so-called “passive” investors here.

Then we also have investors who will buy bonds no matter how negative they get because their methodology dictates it. Just look at pension funds, insurers and central banks. Their policies ensure they continue buying bonds even when that means locking in deeply negative returns over long periods of time.

The incredible growth in this class of price-insensitive buyers is responsible for the everything bubble. Just think about the growth of passive investing over the course of just the past five years or so. Buy and hold has gone from being mocked and disparaged only five years ago to the most popular investment style there is. Witness the growth of robo-advisors as evidence. And how long have central banks been buying assets? It’s only been over the past five or six years. This is a wholly new phenomenon in the markets and it’s now become a huge segment.

Make no mistake. The incredible growth of “value agnostic” investors is just another form of mania pushing asset prices to extremes. These investors use their returns over the past five years as proof that their methodology has merit when simple common sense shows that you can’t possibly be an investor while denying the definition of an “investment,” as Ben Graham defined it:

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Buying stocks or bonds today provide neither “safety of principal” nor “adequate return.” In fact, these “price-insensitive buyers” don’t even attempt to begin any sort of “thorough analysis.” For this reason they are nothing more than speculators. That they believe themselves to be otherwise despite the obvious fact that they are just the opposite may be the surest sign there is that this is indeed another mania. Sadly, it will only be evident to them in hindsight.


Why A Stock Market Crash May Once Again Be Inevitable

Don’t confuse brains with a bull market. -Humphrey B. Neill

Spending as much time as I do on social media, namely Twitter and StockTwits, I’ve been absolutely astounded by how many traders have begun to “confuse brains with a bull market.” We joke about it on these platforms but there is an amazing amount of hubris out there right now.

One of my favorite investing quotes comes from an interview Paul Tudor Jones gave just after the financial crisis had ended:

Clearly, many fundamental investors were caught off guard by the crisis. Stocks they thought were cheap in 2007 got far cheaper over the coming couple of years. Being unable to “read the tape,” these investors suffered the full force of the stock market crash.

As a response to this failure, many investors have seemingly tried to adapt by becoming “tape readers.” Most notably I have seen an explosion in the number of traders calling themselves, “trend followers.”

Now I have great respect for trend-following. Some of the greatest investors on the planet are trend followers, employing a very simple yet very effective and intuitive strategy across a wide variety of markets.

That said, the problem with most of these newbie trend followers is they ignore one of the key components of the strategy: diversification. They are involved only in one asset class, the stock market. Though they respect the trend, they don’t appreciate just how exposed they are to liquidity risk right now, something experienced trend followers ameliorate by broadening out into as many uncorrelated asset classes as possible.

Emboldened by 3+ years of very low volatility, these traders have become the exact opposite of what PTJ was referring to. Their inability to understand the fundamentals, relying solely on the trend, puts them at great risk, especially in an environment of problematic liquidity.

As I’ve demonstrated over the past several months, this stock market is one of the most overvalued, overbought and overbullish in history. Julian Robertson, Stan Druckenmiller, Ray Dalio, Mohamed El-Erian and other super-investors have recently warned about this in one way or another.

However, when I have shared the their concerns via social media, I’m regularly met with dismissal or disdain. These trend followers have become so emboldened by the bull market that they now believe their brains to be even bigger than these giants of the industry.

I have been bearish but have avoided using the “c-word” until now because crashes, by their nature, are impossible to predict. But the hubris on display in the market by those who believe themselves immune to these massive risks has me wondering if some sort of liquidity event in the stock market isn’t inevitable.

If everyone is a trend follower and the stock market begins to sell off, how can everyone get out at the same time? And in a market already plagued by severe liquidity challenges? It seems to me that there is a lesson here that should have been learned a long time ago.

The quote above comes from a fantastic piece Mark Yusko recently wrote about his personal experience with Julian Robertson, who recently said it is, ‘not at all ridiculous to expect another 2008-style decline in the stock market.’

To turn the PTJ quote on its head, counting on being able to sell once it’s clear to all that the trend has shifted may be precisely how those in the trend following space get annihilated in the future. Certainly, we have seen this movie before. Doesn’t anyone else remember “portfolio insurance”?


Why Record-High Margin Debt Should Make You More Cautious

It’s recently become popular to dismiss the record level of margin debt in the market as meaningless. Notable bloggers like Josh Brown, Barry Ritholtz and Chris Kimble have all written some sort of “it just doesn’t matter” commentary recently. Barry went so far as to call it, “statistically bogus.” To me, this sounds like just another version of, “it’s different this time.”

Here are the real statistics: Over the past 20 years, the level of margin debt relative to the economy has had nearly an 80% negative correlation to future 3-year returns in the stock market. What this means is, the higher the level of margin debt relative to GDP, the lower the returns for the stock market over the coming 3 years and vice versa. “Statistically bogus?” I think not.

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So what is the current level of margin debt suggesting for the next 3 years in stocks? Considering that margin debt-to-GDP is near an all-time record high, it forecasts returns over the coming 3 years could very well be as bad as any bear market we have witnessed over the past 20 years. Specifically, it forecasts a negative 3-year return of 50%. Maybe this is one reason Julian Robertson recently said it’s not “ridiculous” to expect another 2008-size decline in the stock market.

Screen Shot 2015-05-06 at 9.46.52 AMNow I’m not saying that this one indicator should be relied upon on its own in making investment decisions. 20 years of data is not much and it’s only one of many valuable indicators. But to call it meaningless is either willful ignorance (aka, cognitive dissonance) or disingenuousness.

Because it is statistically significant, it is very valuable in, as Howard Marks says, “having a sense for where we stand.” From The Most Important Thing:

As difficult as it is to know the future, it’s really not that hard to understand the present. What we need to do is “take the market’s temperature.” If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do… Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious.

In my view, margin debt is a very good way to “take the market’s temperature.” The extreme level of margin debt-to-GDP clearly shows investors have become “recklessly confident.” Prudent investors should react by becoming more cautious. And, from a contrarian standpoint, the fact that popular bloggers are dismissing this idea despite its mathematical validity adds an exclamation point to that idea.


It’s Going To Take A Major Bear Market Before Stocks Can Live Up To Investors’ Lofty Expectations

The Nasdaq recently set a new all-time high, 15 years after it set it’s last one. Investors who bought back then believing no price was too high to pay in order to hop on the dotcom bandwagon learned the hard way that, “the price you pay determines your rate of return.” This is an iron law of the markets. If you overpay you essentially lock in subpar returns for a long period of time.

Think about it this way. You’re buying some wholesale product to resell. Let’s just use beard oil as an example. You know you can sell the beard oil for $10 per jar. If you can buy them for $5 you can double your money every time you sell a jar. But if you pay $9 each you’re going to earn a lot less on each sale. Buying the Nasdaq in 2000 was like paying $40 per jar. Inflation (sales and earnings growth, in the case of Nas cos.) has now finally caught up so that these investors can now sell their jars of beard oil for their original cost.

Paying an incredibly high multiple of earnings for the Nasdaq back in 2000 guaranteed buyers that they would receive poor returns over the next 15 years. Even the broader market at the time was priced to disappoint investors as Warren Buffett famously wrote in Fortune back in November 1999.

What investors need to know today is that they are currently priced just as high as they were back then! The problem is they once again want their cake and to eat it, too. Despite paying an extremely high price for stocks today they also expect a high rate of return. A few recent polls show investors expecting to get 10% per year from their equity investments right now. Some are even expecting to generate twice that much and there’s just no chance it’s going to happen.

Warren Buffett’s favorite valuation measure is nearly 90% correlated to future returns in the stock market. It’s what he referred to in his November, 1999 piece when he wrote that investors were destined to be disappointed by their returns over the coming decade (now known as the lost decade). Based on how high this measure shows stocks are currently valued, it forecasts an average annual return of about -0.5% over the coming 10 years.

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Now if you want to generate a 10% return buying the major stock market indexes like the S&P 500 you’ll need to pay a much lower price. Using similar measures, it’s fair to estimate that you would have to pay about 940 on the S&P to generate a 10% forward return for the coming decade. In other words, it would take a decline of more than 50% to set up the opportunity for the stock market to provide double digit returns once again.

So if you do want to earn 10% per year on your stock market investments you should be rooting for a major bear market. Because without one you’re going to be just as disappointed as those who bought stocks back in November of 1999. Like Nobel Prize winner Bob Shiller recently said, you’ll likely wake up 20 years from now and realize your investments have gone nowhere. And during that time, there will undoubtedly be a few opportunities to buy stocks at much better valuations and thus offering much better forward returns just like we’ve seen over the past 20 years.