jesse_livermore
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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.

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alfred-e-neuman
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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”?

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alfred-e-neuman
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Playing Defense In The Stock Market Right Now Doesn’t Make You An Idiot

I’ve taken some flak recently for my persistently bearish views of the stock market over the past year. Rightfully so. I’ve been dead wrong. And with a record level of bulls it should come as no surprise that they’d like gloat.

But I’d like to make a few things clear. First, I’m not a perma-bear. Far from it. I was rip-snorting bullish on stocks back in early 2009 when it was very painful and lonesome to be such. And when the broader stock market presents investors with another good buying opportunity I won’t hesitate to get bullish again.

Second, just because I “worry top down” that doesn’t prevent me from successfully investing “bottom up.” I was very bullish on Apple a couple of years ago when it was also painful and lonesome to be such. I also turned very bullish on Herbalife earlier this year. Even if these trades were fully hedged they would have crushed the S&P. My worries are also one reason I’ve been bullish long bonds, another trade that has crushed the stock market.

I really find it funny that stocks are the only asset class where if you don’t own them – and today that means owning the index – when they go up you’re an idiot. What about those who didn’t own gold in the 2000’s? Or those who didn’t short financials in 2008? Or those who haven’t owned long bonds over the past few years? Why aren’t you an idiot for missing these trades?

Right now there’s a zeitgeist. It’s a mantra among investors that if you don’t own stocks 100% of the time you’re a loser. To me this is asinine. There have been plenty of times throughout history where owning stocks was a loser’s game and today has all of the makings of another one. And the zeitgeist, itself, is compelling anecdotal evidence of that!

One of the best rules anybody can learn about investing is to do nothing, absolutely nothing, unless there is something to do… I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up… I wait for a situation that is like the proverbial “shooting fish in a barrel.” -Jim Rogers in Market Wizards

I look for compelling risk/reward setups. That’s my personal style and it works for me. As I see it, the current risk/reward equation for owning an equity index fund is all risk and no reward. And some very smart people agree with the idea.

Ultimately, I still believe it’s time to play defense:

Marks became bearish on “riskier debt markets” way back in 2004. Just because he was three or four years early does that make him an idiot? Of course not. Did playing defense cost him performance during those years? Yes. But was it worth it? Absolutely. Playing defense was critical to surviving the financial crisis.

Knowing when it’s time to play defense versus offense is critical to staying power in this game. I’ve been through a number of cycles now in my career. I’m not going to simply decide one day to ignore the risks I see just because they haven’t materialized over the past 12 months. I don’t need to own an S&P 500 index fund to make money when there are plenty of other far more compelling ways to do so.

And the single reason I continue to share my bearish views on stocks is that I truly care about trying to help long-term investors avoid another painful lesson. In fact, that’s exactly what I’ve been doing here for nearly a decade now.

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Ulysses_and_the_Sirens_by_H.J._Draper
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Don’t Be Seduced By The Siren Song Of The Stock Market

I recently wrote that, “the single greatest mistake investors make is to extrapolate recent history out into the future.” As an example of how dangerous this natural tendency is, I shared a bit of Warren Buffett’s warning from late 1999 in which he wrote that the amazing returns from the stock market during that period had led to investor expectations rising far too high. He forecast that the coming decade would not be nearly as rewarding as investors were hoping it would be. Clearly, the “lost decade” that followed vindicated this idea.

Recently, the Wall Street Journal ran a story about investor expectations once again becoming “delusional.” And with the 200% gain in the stock market over the past six years we probably shouldn’t be surprised. When stocks return 20%+ per year for a few years investors become accustomed to it. It’s only natural to extrapolate recent history into the future even if it is also extraordinarily dangerous to your financial health.

Earlier this month, Nautilus Research shared on twitter the chart below which shows exactly how dangerous this natural tendency really can be:

This is only the fourth time in history the stock market has risen 200% over a six year period.  Exactly six years ago, when I wrote that the market presented investors with an ‘opportunity of a lifetime,’ I was rip snorting bullish but still never dreamed the following six years would be so rewarding.

And while it may be difficult to base anything on only 3 previous occurrences, returns after each of these amazing runs were lackluster at best. History has not been kind to investors acting on their natural tendency to extrapolate.

In fact, only the 1955 occurrence shows a positive subsequent return on a 2, 3 or 5-year time frame. The one thing that sets this occurrence apart, however, is that valuations back then, based on Warren Buffett’s favorite metric (total market capitalization-to-gross national product), were about half what they are today.

fredgraph

As I wrote previously, today’s stock market is priced just as high as it was in November 1999 when Buffett wrote his warning in Fortune. For this reason, the April 1999 occurrence in the Nautilus study is probably much more relevant to our current situation than the 1955 one. And there is good reason to believe that this market is even more insidious than the one that peaked 15 years ago this month.

The stock market today is calling to investors just as the sirens of Greek mythology called to sailors drawing them into their rocky shores only to be shipwrecked. Extrapolating the fantastic recent returns into the future despite all the evidence against it is succumbing to the stock market’s perfidious seduction. And history suggests that’s almost a sure way to shipwreck.

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Why The Smart Money Is Beginning To Worry About The Downside

A month or so ago, I was struck by Ray Dalio’s comments at Davos. He seemed fairly concerned and the major media outlets didn’t really pick it up.

“It’s the end of the supercycle. It’s the end of the great debt cycle.” –Ray Dalio

What does this mean? I think the simplest explanation is that over the past several decades we’ve gone from a nation of savers who paid cash for things including homes and cars to a nation of spenders who use debt like mortgages, car loans and credit cards to pay for things.

And it’s not just on the consumer level. It’s also happened at the corporate level.

“Corporate debt was $3.5 trillion– in 2007, arguably a period and– many would describe as bubbly. It’s 7 trillion now. So it’s gone from 3.5 trillion to 7 trillion. As you know, most of that mix has been in more highly leveraged stuff, Covenant-Lite loans– high yield, that’s where the majority of the rise has been. And if you look at corporations have been using it for, it’s all financial engineering.” –Stan Druckenmiller

Government debt has also grown to multiples of GDP around the world. But it can’t keep growing forever.

“In the past 20 to 30 years, credit has grown to such an extreme globally that debt levels and the ability to service that debt are at risk, relative to the private investment world. Why doesn’t the debt supercycle keep expanding? Because there are limits.” –Bill Gross

The debt boom over the past few decades has been a big economic stimulant. It reminds me of the steroids era in baseball. You take a great player, put him on the juice and he becomes a record-breaking home run machine.

But what happens when he comes off the juice? Have you seen a picture of Mark McGuire or Sammy Sosa lately? They are shadows of their former selves. Now that rates are zero and everyone has borrowed as much as they possibly can debt is no longer the super-stimulant it once was.

“The process of lowering interest rates causing higher levels of debt, debt service and spending, I think is coming to an end.” – Ray Dalio

The steroid era is over. So what are the implications for the economy and the markets?

“The implications are much lower growth, less inflation, lower interest rates, and less profit growth.” –Bill Gross

These are all symptoms that we’ve already witnessed since the financial crisis, right? Slower economic growth has been partially masked by rising asset prices and the wealth effect. Slower profit growth has been masked by the “financial engineering” Druck mentioned above. But that doesn’t change the fact that we are now facing a post-steroid era for the economy.

“We brought consumption forward and issued one giant credit card for the past 30 years. Now the bill is coming due. Investors need to get used to low returns, and low growth, inflation, and interest rates for a long time.” –Bill Gross

What’s probably most troublesome about the whole situation is that now that rates are zero or negative, debt levels have reached their maximum capacity and asset prices are already inflated (and spreads flattened), central banks no longer have the ability to ameliorate an economic slowdown by easing monetary policy.

“Central banks have largely lost their power to ease… We now have a situation in which we have largely no spreads and so as a result the transmission mechanism of monetary policy will be less effective. This is a big thing… So I worry on the downside ’cause the downside will come.” –Ray Dalio

With corporate debt levels twice what they were before the financial crisis, the covenants on much of that debt weaker than ever before and liquidity in the bond market disappearing, the next downturn could present a unique challenge for the Fed. And their traditional tool to address these sorts of challenges is now essentially impotent. No wonder Dalio is worried.

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