Bear Market Buying Debunked

http://community.marketsmith.com/telligent/b/blogs/archive/2011/09/29/8097.aspx

The hardest part for investors sitting out during a market correction is their conflicted thoughts about missing potential opportunities. They fear the market will leave them behind, or they want to get back in early. But the impulse to make money by fighting the market’s trend can be costly. In a bear market, two of the biggest temptations for such investors are 1) Dividend-paying stocks (especially in the Dow) and 2) the continued fundamental strength of the prior cycle’s leading stocks. The excessive risk in this environment makes gains on long positions doubtful, but these two “potential opportunities” have even clearer flaws.

First, the problem with dividend stocks in poor market environments is that price depreciation can wipe out gains made from the dividends. See the net losses on the top 7 well known dividend paying stocks in the table below.

	Dividend Yield	Relative Strength Rating	Price Chg YTD	Net Gain/Loss
FTR	12.3	26	-37.00	-24.70
LEG	5.6	49	-11.29	-5.69
HPQ	2.0	10	-43.97	-41.97
DD	4.0	38	- 15.28	-11.28
GE	3.8	47	-15.53	-11.73
CAT	2.5	32	-17.07	-14.57
CSCO	1.5	61	- 20.80	-19.30
KFT	3.4	88	8.63	12.03
MCD	3.2	92	14.68	17.48
IBM	1.7	94	20.98	22.68

Relative Strength (RS Rating) is usually more relevant to overall gains in stocks than dividend yields (KFT, MCD and IBM in the table above). If you have to own dividend paying stocks now, the high RS stocks are the ones you want to own, because by definition they are holding up the best. If you are tempted to buy solely because the dividend looks attractive, you may be taking on more risk than you realize. Remember a position in cash isn’t yielding anything, but at least you are not going backwards.

The other temptation stems from the fact that the fundamental stories that propelled the leading growth stocks of the last bull cycle are still intact. “Buy them now while they are cheaper” has been said about stocks like GMCR, CMG, PCLN, LULU, and AAPL. While the fundamentals continue to be impressive for these leaders, the problem with buying them now is that you are guessing that the market has bottomed here. Without confirming that a new uptrend has begun by consulting your stock charts, these stocks and the market could very well continue lower.

To soften the severity of the market’s weakness, many would like to write off the action of the leading stocks as simply “an overreaction by momentum stocks.” But why all of a sudden are these stocks being labeled as “momentum”? Investors should recognize that these stocks are some of the leading growth stocks since the market uptrend began in March of 2009. All have formed late stage bases and are vulnerable to topping. Most breakouts have failed and have, or are about to undercut the lows of their most recent base. In the end, strong fundamentals are not enough to fend off the topping cycle all stocks eventually go through. From our decades of studying the behavior of leading stocks, we know that leading growth stocks will correct, on average, 72% from peak to trough. We also know that only 12% will recover and reassert themselves in the next bull cycle. But more importantly, we know that those leaders are an indicator for where the market is probably going next. And right now, there is a higher probability that we are heading lower.

Even AAPL, with some of the best fundamentals out there, will probably get hit if the market keeps sliding lower. Don’t get me wrong, I love AAPL. I own a Mac, an iPad, an iPhone, and an iTunes library full of music. But when the tide drops, it lowers all boats—even that beautiful yacht that everyone wishes was theirs. Admittedly, there may be one to two stocks, or and industry group, that rises during a bear market. But the risk you will take on, and the losses you will incur on the other stocks you buy in trying the find “the one,” will most likely make the entire endeavor of buying stocks unprofitable (until a new market uptrend has begun).

I can even talk up a stock like BIDU, but the same fact still applies. The stock gapped down through its 200-day moving average, and after today (9/29) is now another 10% lower. At least for now, the stock has topped. There is a one in eight chance that it consolidates the price depreciation and sets up to go again in the next bull market. So for now all you can do is sit and watch. Maybe it will, maybe it won’t.

A good example of a terrible stock to be tempted to buy right now is NFLX. Unlike the other leaders mentioned above, this one has had a major negative change to its fundamental story over the last few months. However it continues to be a topic of discussion among investors now because of its merger/partnership rumors with companies like AMZN or Facebook, or content deals with companies like DWA. Given the huge risk in this market and in this stock in particular, why would anyone place a bet on a single event that may or may not occur? That isn’t investing, it’s gambling.

Hopefully most investors won’t have to sift through the endless options and “debunk” each opportunity that comes along while the market is in this correction. The fact that the trend is down should be enough to keep them out.

Mimic Buffett, Lynch And O’Neil With Rules-Driven Investing

http://blogs.forbes.com/investor/2011/05/23/mimic-buffett-lynch-and-oneil-with-rules-driven-investing/

O’Neil, Buffett, Lynch, Livermore and Loeb all strictly adhered to a rules-driven system of investing that led to their enormous success. Employing time-tested and proven systems, these legendary investors were able to avoid such emotional pitfalls as hope, fear, pride and greed, which can destroy a portfolio. They not only used rules when buying, but also when selling; which is all too often ignored, but crucial for preserving profits.

John Maynard Keynes once said, “markets can remain irrational a lot longer than you and I can remain solvent.” Too many investors refuse to accept this wisdom and unfortunately wait in vain for failing investments to recover. However, investors can safeguard themselves by establishing, and sticking to, a set of sell rules that will replace hope with sell discipline, and result in less losses of their hard-earned profit. Remember, a loss of 50% requires a 100% gain just to break even.

My core sell rule? As a growth investor who focuses on industry-leading companies with strong fundamentals, I will always cut my losses at no more than 8% below my purchase price. The basis of this rule is derived from our firm’s historical stock market studies. We thoroughly profiled the most winning stocks in history, and found that after breaking out of a sound chart pattern, leading stocks typically won’t correct more than 7% to 8%.

Once a stock has begun to show a profit, I start to look for abnormal behavior or weakness as a sign it is time for me to sell. Primarily, I am on the lookout for signs of distribution in the form of institutional selling. You can tell that institutions are selling shares if a stock’s price is falling on above average volume, or if the price action is churning (heavy volume without significant price advancement). Other signs of abnormal behavior can include: a stock making new highs on low volume, a stock repeatedly reversing off highs and/or closing near intraday lows, or when it begins breaking logical areas of support like key moving averages and uptrend lines. A stock in a healthy uptrend should be able to avoid most of these negative character traits.

Sell rules can also help you lock in profits before greed takes over, making you hold a stock too long. After I establish a position, I begin to take profits at 20%, even though the stock might very well continue to advance. By doing so, I avoid giving up my hard-earned gains and in the turbulence of today’s stock market, a 20% gain is certainly respectable. Also, stocks will typically consolidate after advancing 20% to 25%, so instead of waiting out the consolidation, I take advantage by reallocating my 20% profit to another stock that is breaking out from a consolidation period or base pattern.

Stocks often flash signs of abnormal exuberance just before the price tops. To help manage my winning positions more profitably, I am always looking for sell signals while the stock price is still moving up. If a stock undergoes more than 2 stock splits in a short amount of time, it may be running out of room to grow. Additionally, if the stock is exhibiting abnormally higher than average volume, or continues to advance until it is extended 70% to 100% above its 200-day moving average, it may be approaching the end of its run or running out of buyers, and it may be time to cash in my shares.

Establishing sell rules that are right for you and having the discipline to stick to them is important. But just as important is remaining a student of the market, and closely analyzing and studying your action. Whatever your style, there is likely a corresponding investment legend with sell rules suited to your approach. Learn from the greats by reading their books, and applying their sell rules to your own investing strategy. You might end up making modifications as you go, but by establishing a set of disciplined rules and removing emotions from the equation, you will have taken a quantum leap toward becoming a better investor.

Style over Stocks

[The following is from p.164-167 of The Guru Investors by John Reese and Jack M Forehand.]

As we noted earlier, Fisher’s investing approach has evolved in many ways since the original publication of Super Stocks. In the 1990s, for example, he began to focus more and more on the importance of investment style. Investors, he said, need to focus on style and to rotate their investment holdings to match the popular style of the time.

One interesting example of what Fisher meant by “style” involves his study of stock returns between January 1976 and June 1995. In this study, he broke stocks down into six styles: big-cap value, midcap value, small-cap value, big-cap growth, midcap growth, and small-cap growth. What he found was that these styles went in and out of favor periodically. From January 1976 to September 1978, for example, small cap value was the leading style, producing an annualized return of 42.69 percent. This beat the loser, big growth, by 37.84 percent. The spread of the best four styles over the worst two was big — 23.25 percent — and the four best styles outperformed the S & P 500 by 23.41 percent.

The bottom line for the entire period studied (January 1976 to June 1995) was:

The annualized return for the best four styles at a given time 17.79%

Annualized market return (Wilshire 5000) 14.64%

Premium of best four styles over the market 3.15%

For Fisher, this was evidence that style selection was a crucial part of achieving excess returns in the market. If you could figure out when certain styles were going to be in favor, you could pick from a wide swath of stocks in that style and do well. To decide which style to pick, he would use certain economic indicators, such as the yield curve (which measures the relationship between shorter- and longer-term interest rates) and how the U.S. gross domestic product (GDP) compared to overseas GDP. Back then, he advocated focusing on what he believed the best four styles at a given time were, and avoiding the worst two. Focusing your investments only on what you believe is the best style at a given time could net you even better returns, but you risked losing a bunch if you picked the wrong style.

As Fisher focused more and more on style, he scrapped the PSR strategy he had detailed in Super Stocks. The reason? He believed that once the masses learned about it, the ratio had become priced into the market. Essentially, more people were focusing on low-PSR stocks, driving their prices higher and limiting the gains you could get from buying them. (We’ll address this and its impact on our model in a bit.)

Today, Fisher remains focused very much on style, so much so that he says only about 10 percent of his strategy involves actual stock selection. He writes in “The Only Three Questions That Count” that about 70 percent of it involves assessing various economic, political, and sentiment drivers to determine asset allocation — that is, how to divvy up investment dollars among stocks, bonds, and cash. Another 20 percent is “sub-asset allocation,” which involves deciding which countries, which sectors, which types of market capitalizations, and which styles (value or growth) to invest in. Only after he’s determined how much of his portfolio to put in stocks and which categories of stocks he’s interested in does he start looking at individual stocks. From there, he says, he goes category by category (one category might be “U.S. small-cap value industrials”, for example), and picks a few stocks from each.

How does he pick those stocks? Part of it is fundamentals (in one example he mentions in “Three Questions,” he even notes that a stock he liked was selling at a low price for its revenues — essentially meaning its PSR was low). But a big part of it is non-quantitative, as is the way he decides his asset allocation and sub-asset allocation. One of the key points in “Three Questions” is that, according to Fisher, “You can’t make market bets and win long term unless you know something others don’t.” It’s the same concept behind his reason for ditching his low - PSR approach: Once the masses are aware of an investment 166 the growth legends strategy, it gets priced into the market. That’s why one of the three questions the book’s title refers to is “What Can You Fathom That Others Find Unfathomable?”

One example Fisher gives of something he can fathom but most investors can’t is the “presidential term cycle.” Part of this phenomenon is that, historically, stock returns are much better in the third and fourth year of a president’s term than they are in the first two years. Fisher surmises that investors are more hesitant in the first part of the term because that’s when big changes can occur as the president begins to put his or her agenda into action. In particular, one thing that can occur is the redistribution of wealth through tax and other legislative changes, something that makes Wall Street very cautious. By the third and fourth years, however, the president has settled in and controversial legislation is unlikely because he or she is trying to get reelected or is simply tired and hanging on as their term winds down. Investors have more of an idea what they can expect, so they’re more likely to be bullish, the theory goes.

Fisher is also a big proponent of looking at global economic indicators — not just those that reflect conditions in the United States. He uses the global yield curve (the spread between shorter - and longer - term interest rates) as a way to discern whether to focus on growth or value stocks, for example. “Simply put, the global yield curve tells you when to switch from value to growth and back,” he writes. “After it has gone completely flat, you head into a period of growth stock dominance. After it gets very steep, you switch into value stock dominance. After it flattens, it’s time to tilt to growth again.” Fisher focuses on the global yield curve rather than the U.S. yield curve because, “If one country’s yield curve inverts while the global yield curve remains positive, there are still opportunities for businesses, institutions, private clients, and so on to continue doing business globally.”

Fisher also considers factors such as the global gross domestic product and global inflation. This global focus, particularly the global yield curve information, is another example of how Fisher takes advantage of knowing something that most other investors don’t know. (Be aware that Fisher doesn’t base his approach on just one thing that he can fathom but others can’t — “Never assume you have found the one silver bullet,” he writes.)

The presidential cycle, global yield curve, and other atypical factors Fisher uses today to guide his investment approach are quite interesting, but, to Fisher, they’ re not carved in stone. “The advantages I showed you will all fade away one day” as they become known and priced into the market, he writes. That’s why it’s critical, he says, to continue to try to fathom what other find unfathomable. “Winning at investing requires constant innovation and constant testing,” he says. Put another way, you have to be willing to go against the Wall Street grain to win in the stock market. That same rebelliousness that led Fisher to focus on the PSR years ago is still there; it’s just in a different form today — and it could be in a different form tomorrow, next month, or next year, depending on what happens in the investing world.

The Cornerstone Investing System

http://www.selfgrowth.com/articles/the-cornerstone-investing-system
By Victor Chan Wai-To

The Cornerstone investing system is a simple investing approach developed by fund manager James O’Shaughnessy. His book What Works on Wall Street, which first publicized the Cornerstone system in 1996, soon became a bestseller and is since then updated several times because of the amazing simplicity of the Cornerstone system, as well as the robust returns it generates.

The Cornerstone system actually consists of two separate strategies: one focuses in growth stocks, another in dividend stocks, and they are unified by a sound capital allocation between the two strategies. Here are the details.

The Growth Strategy

The first half of the Cornerstone investing system is called the growth strategy, which aims to buy stocks with growth potential at a reasonable price. Here are the four parameters of the strategy:

I. Market Capitalization

The first requirement of the growth strategy is that the company must have a market capitalization of at least $ 150 million, because otherwise the company is too illiquid for most investors.

◆ Growth Criterion 1: Market cap must be at least $150 million.

II. Earnings per Share (EPS)

The strategy requires companies to have persistent earnings growth, where the earnings per share before extraordinary items must increase each year for the recent five years.

◆ Growth Criterion 2: Annual EPS must be increasing year after year for the past five consecutive years.

III. Price-Sales Ratio (P/S)

Along with another investing legend Ken Fisher, O’Shaughnessy is also a zealot of the price-sales ratio. He found that the P/S ratio was the single best predictor of a stock’s value in the future, and he targets stocks with price-sales ratios below 1.5 to identify growth stocks that are still cheap to buy.

◆ Growth Criterion 3: The price-sales ratio must be smaller than 1.5

IV. Relative Strength

Relative strength (RS) is a technical criterion that measures the difference between a stock and a benchmark index (e.g. Russell 1000) within a time period (e.g. 12 months). Say, if a stock has a 12-month RS of 90 against the Russell 1000, it means that in the past 12 months, the stock is performing better than the Russell 1000 for 90% of the time.

After you selected all the candidate stocks based on the previous three criteria (market cap, EPS, P/S), you rank them according to their relative strength in 12 months, 6 months and 3 months respectively. You are only allowed to invest in the stocks which are present in the top 50 in all three lists. The benchmarks used here are the Russell 1000 (for large cap stocks) and the Ibbotson Small Stocks Index (for small cap stocks).

◆ Growth Criterion 4: RS in 12 months, 6 months and 3 months must be in the top 50 of all candidates that satisfy the previous three criteria.

The Value Strategy

The other half of the cornerstone investing system is the value strategy, which in contrast to the growth strategy, targets large companies with nice cash flows and solid dividends. This strategy does not include utility stocks because of their high yields. The benchmark used in this strategy (e.g. market averages of financial data) is the Russell 1000 Value index.

I. Market Capitalization

The value strategy looks for large, well-known companies with market capitalizations greater than $ 1 billion, as O’Shaughnessy found that they can provide steady dividends more often.

◆ Value Criterion 1: Market cap must be at least 1 billion.

II. Cash Flow per Share (CFPS)

O’Shaughnessy seeks companies whose cash flow per share exceeds the average cash flow per share of the market, because strong cash flows are typically what the institutional long-term investors look for.

◆ Value Criterion 2: CFPS must be greater than the market average.

III. Shares Outstanding

O’Shaughnessy seeks companies with a large number of outstanding shares, because these are the better known and liquid stocks.

◆ Value Criterion 3: Shares outstanding must be greater than market average.

IV. Trailing 12-Month Sales

High trailing 12-month sales is a hallmark of earning consistency. As a general rule, a company’s trailing 12-month sales should be 1.5 times or greater than the average market value.

◆ Value Criterion 4: Trailing 12-month sales must be at least 1.5 times of the market average.

V. Shareholder’s Yield

Shareholder’s yield is a term defined by O’Shaughnessy as the dividend yield plus the net decrease of shares (in percentage) in a given period. For example, if the dividend paid for the previous year was 1%, and in the same period the company repurchased 5% of the outstanding stocks, then the shareholder’s yield would be 6%. Conversely, if the company issued new shares instead, then it has to be deducted from the dividend yield.

After you selected all the candidate stocks based on the previous four criteria (market cap, cash flow, outstanding stocks, sales), you rank them according to their shareholder’s yield and only invest in the top 50 stocks.

◆ Value Criterion 5: Shareholder’s yield must be in the top 50 of all candidates that satisfy the previous four criteria.

Allocation and Rebalancing

After some research into portfolio allocation, O’Shaughnessy finds an ideal allocation of capital to be the following:

• 50%: Value strategy in large cap stocks (benchmark: Russell 1000 Value).
• 35%: Growth strategy in small cap stocks (benchmark: Ibbotson Small Stocks).
• 15%: Growth strategy in large cap stocks (benchmark: Russell 1000).

O’Shaughnessy also practices a periodic rebalancing of portfolio, i.e. selling existing stocks that no longer meets your criteria, and reinvest in new opportunities at a fixed interval of time. Originally, O’Shaughnessy recommends rebalancing your portfolio every year after your purchase because of US tax reason (long-term capital gain tax). However, later research found that, if tax is ignored, it is actually better to rebalance at a shorter time intervals (e.g. quarterly or even monthly), especially for the growth strategy with small cap stocks.

Discipline

Regardless which strategy, allocation or rebalancing period you choose, O’Shaughnessy made it clear that the most important thing is to have the discipline to stick to your method, even when it is underperforming relative to other strategies every once in a while. As he wrote:

“Sounds simple and sensible [to get rich with these simple rules], yet many investors have a nearly impossible time following this simple advice… I passionately believe that investors who manage to short-circuit their underlying emotions by following a simple equity asset allocation plan with consistent discipline will vastly outperform those who are unable to do so, whatever the overall market environment. By letting the data of 108 years inform us — rather than listening to what a talking head is saying right now on the TV or internet — we can see the simple truth that using simple, straightforward and time-tested investment strategies leads to the best overall results in virtually all market environments.”

Conclusion

Here is a summary of the Cornerstone investing system:

The Growth Strategy:

1. Market Cap > 150 million.
2. Earnings per Share: Increasing for 5 years.
3. Price-Sales Ratio < 1.5.
4. Relative Strength: Top 50 of Candidates.

The Value Strategy:

1. Utility stocks not included.
2. Market Cap > 1 billion.
3. Cash Flow per Share > Market Average.
4. Shares Outstanding > Market Average.
5. Trailing 12-month Sales > 1.5 x Market Average.
6. Shareholder’s Yield: Top 50 of Candidates.

Allocation and Rebalancing:

• 50% of value with large cap stocks.
• 35% of growth with small cap stocks.
• 15% of growth with large cap stocks.
• Rebalance the portfolio at least once a year.

How to Identify a Correct Base in a Stock

Base Checklist: How to Distinguish Between Sound & Faulty Patterns

http://www.investors.com/MediaCenter/567931/201103281850/IBDextra-April-2011-and8211-In-The-Spotlight.aspx

Video: http://www.investors.com/video/2011_04_Spotlight.flv

The Great Paradox in Stocks

[The following is from p.174-176 of How to Make Money in Stocks (4th Edition) by Williams O'Neil (2011). McGraw-Hill.]

The staggering majority of individual investors, whether new or experienced, take delightful comfort in buying stocks that are down substantially from their peaks, thinking that they are getting a bargain. Among the hundreds of thousands of individual investors attending my investment lectures in the 1970s, 1980s, 1990s and 2000s, many said they do not buy stocks that are making new highs in price.

The bias is not limited to individual investors, however. I have provided extensive historical precedent research for more than 600 major institutional investors, and I have found a number of them are also “bottom buyers.” They, too, feel it’s safer to buy stocks that look like bargains because they're either down a lot in price or actually selling near their lows.

Our study of the greatest stock market winners proved that the old adage “buy low, sell high” was completely wrong. In fact, out study proved the exact opposite. The hard-to-believe Great Paradox in the stock market is:

What seems too high in price and risky to the majority usually goes higher eventually, and what seems low and cheap usually goes lower.

Are you finding this “high-altitude paradox” a little difficult to act upon? Let me cite another study we conducted. In this one, we analyzed two groups of stocks – those that made new-highs and those that made new-lows – over many bull market periods. The results were conclusive: stocks on the new-high list tended to go higher in price, while those on the new-low list tended to go lower.

Based on our research, a stock on Investor’s Business Daily’s “new price low” list tends to be a pretty poor prospect and should be avoided. In fact, decisive investors should sell such stocks long before they ever get near the new-low list. A stocks making the new-high list – especially one making the list for the first time while trading on big volume during a bull market – might be a prospect with big potential.

Not to Convince, But to be Convinced

http://www.marketoracle.co.uk/Article26819.html
By Victor Chan Wai-To

The most valuable mantra in investing goes by: “Not to convince, but to be convinced.” A good investor does not take unnecessary chances and then convince himself that everything would be alright. Rather, he would wait until the right opportunity comes by and convinces him that it is the choice to make. In other words, a winning investor always abides in stillness until a high-probability signal dawns on him.

Let the Winner Proves Itself

For example, a momentum investor refrains from buying a fundamentally sound stock until its price has broken out to a new high. The reason is that, whenever the price reaches the higher end of the range, short-term investors would anxiously sell for a quick profit, while the long-term investors would begin accumulating those shares just being sold. The price would finally succeed in breaking into a new high when there are no more sellers to push the price back down, i.e. all stocks are transferred from bears to bulls, which means that there is no more resistance against the price to go up, and this is the safest time when you can put your capital at risk.

If you buy a stock long before the breakout occurs, chances are it may remain going sideways or even plunge down later, because your analysis of the stock may not be correct after all, and you forgo better opportunities by sticking your capital with a loser. It is against human nature to give up a bargain, but it would be risky to buy under an unconfirmed situation. This is especially true if the current market is in a correction mode, which gives us more reason to wait for a properly formed breakout. This is why instead of trying to predict the future, we patiently allow the stock to prove itself, and buy at the proper time as indicated by a change in price and volume.

ASSUME = ASS U and ME

Therefore, instead of assuming what will happen, you should simply wait for the market to confirm what you are assuming. One of my favorite jokes on the English language is that, “The word ‘ASSUME’ spells ‘ASS U and ME.’” Most financial analysts make the mistake of assuming that they know a lot about the market, and make predictions that are wrong for 50% of the time. It is ego play instead of investing, and unfortunately the smarter the individual is, the more prone he is to fall into this trap. This explains why so many bright people, including those really knowledgeable professionals like Julian Robertson and Victor Niederhoffer, were blown up in the financial market simply by not admitting they were wrong when the market told them the truth.

A great investor does not assume that he can always be right in the market, and instead he knows the only one who is always right is the market itself. As legendary stock operator Jesse Livermore pointed out that the aim of the game is not about being right, but about how much you can make when you are right. Therefore the difference between the stock “expert” and the true winner lies in that, while the “expert” always has to appear confident, pour out myriad of theories of fundamental analysis and make calls on the market, the profitable investor, on the other hand, believes that he could never be smarter than the market, and let only the market, instead of anyone else, to tell him whether he is right or wrong.

The Lure of Omniscience

As Sherlock Holmes said, “It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.” All these troubles begin with the human urge to demonstrate omniscience by predicting events before they occur. It is almost like you would need to have an IQ of 200, the knowledge of a PhD, and some enormous insider information to make you successful in the market. As a result, you can see a lot of amateur investors spending a lot of money on expensive seminars to learn some obviously pointless methods like astrology, simply because it is too alluring to know how to predict the future. They do not realize that investing success is as simple as patience and humbleness.

The 80/20 Rule in Investing

To cure this, one must understand that the 80/20 rule applies in investing that, for most of the time, you simply do nothing. As Livermore warned, “No man can always have adequate reasons for buying and selling.” In other words, there are times when the correct trade is sitting in cash. Many otherwise profitable investors give back profits by overtrading, and they would surely benefit from the discipline of momentum investing by only buying on strength as proven by a breakout.

Livermore believed that timing was everything to a speculator, so that it is never about if a stock is going to move, but when. Although it seems quite obvious, many investors simply do not bother, as they would buy the stocks they want anyway, and wait for the move to play out, and hope that everything would be alright. The market may eventually move in the desired direction, but it may also not. It is simply not sensible to be exposed in the market before a confirmation, just to hope that it would turn out fine.

Summary

A good investor does not buy a stock and convinces himself it is correct. Rather, he waits for an opportunity to prove itself to him. The reason is that the market has its own cycles of profitable and barren periods, and the former is way less often than the latter. By not imposing one’s own logic and ego onto the market, he will be able to see the market as it is, and hence keeping the powder dry until the best opportunity presents itself. Unfortunately, conquering one’s own ego is the most difficult task in the world, especially for those who consider themselves more knowledgeable than average. Still, it is only after an investor has acquired this habit to “be convinced but not to convince”, he is able to make money.

The Trading System of Jesse Livermore.

http://www.marketoracle.co.uk/Article26363.html
By Victor Chan Wai-To

A butcher never chops with a blunt knife, yet it is common to see a trader operates with an unsound trading system. The fastest way to get a winning system is to steal one from a successful trader, and for that matter, there is no better candidate than legendary trader Jesse Livermore, because his method was very simple: it contained only three components, which are respectively known as the reversal pivotal point, the continuation pivotal point, and the symptoms of weakness. Their application would be explored in this article.

1. Reversal Pivotal Points

The first component of Livermore’s system is the reversal pivotal point, which is defined by Livermore as “the perfect psychological time at the beginning of a new move, representing a major change in the basic trend.” However, confirming a market turn in real time is not easy, e.g. when there is a rally in a long bear market, how can you tell whether it is just temporary, or the bull market has returned? You can use the following four steps to justify:

1. The bear market rally does not get retraced below its starting point.
2. Within two weeks after the initial rally, an even bigger rally follows.
3. The volume of this subsequent rally is significantly higher than previous days.
4. This subsequent rally usually breaks the trend line of the previous bear market.

This monumental subsequent rally is exactly what Livermore called a reversal pivotal point, because it marks the return of large investors into the market, and although the market often corrects on furious volume immediately afterwards, it usually rebounds soon and begins a new trend.

2. Continuation Pivotal Points

The second component of Livermore’s system is the continuation pivotal point, which concerns the time to enter the market. While a reversal pivotal point marks a trend reversal, a continuation pivotal point confirms that the trend continues.

According to technical analyst R. N. Elliott, a trend is composed of impulsions and corrections: whereas impulsions are the parts in which the price drifts rapidly with the trend, corrections are the consolidation parts in which stocks are accumulated before the market takes off again, and this breakout from consolidation is known as the continuation pivotal point, where a trader should get in and follow the trend.

Stock expert William O’Neil believed that buying at continuation pivotal points is one of the greatest secrets in trading stocks, because the price seldom falls for more than 10% after a genuine breakout. Therefore, the primary job of a trader is to recognize a genuine breakout from consolidation, to identify which O’Neil listed out three clues to look for:

Clue 1: A Sound Pattern:

The consolidation is usually in the form of a sound chart pattern. The most common pattern, according to O’Neil, is the cup-and-handle formation, where the price forms a concave shape of a bowl (the “cup”) with a small pullback at the end (the “handle”). Patterns formed within seven weeks are usually weak and should be considered carefully. Limited by the size of this article, please refer to How to Make Money in Stocks by William O’Neil for more discussion on chart patterns.

Clue 2: A Tight Accumulation:

A good breakout depends on the “tightness” of the accumulation (e.g. the “handle” part of a cup-and-handle). If the consolidation has a narrow day-to-day change relative to the weekly range, it is then considered more reliable than a “wide and loose” one.

Clue 3: A High Volume upon Breakout:

Most importantly, just as for a reversal pivotal point, a true breakout at a continuation pivotal point is usually accompanied with a higher volume than the previous few days.

3. Symptoms of Weaknesses

The last part of Livermore’s system is called the symptoms of weakness, which concerns the question of when to exit. As Baron Rothschild had allegedly said, “I never buy at the bottom and I always sell too soon.” The best time to sell is upon the signals of trend exhaustion when the following symptoms of weakness appeared in the market:

Symptom 1: Head-and-Shoulders

William O’Neil pointed out that head-and-shoulders are the most common pattern in a topping market, where the peak of the market (the “head”) is surrounded by two lower peaks (the “shoulders”) on both the left-hand and right-hand side respectively, especially when the right shoulder is lower than the left shoulder. Sometimes, the market will perform what is known as a “head test” when the price rebounds immediately after the right shoulder is formed, and tests the “head” level of the pattern before falling again. Examples of the head-and-shoulders pattern are the Dow in August 1987 (without head test) and in July 1976 (with head test).

Symptom 2: Period of frequent distribution days.

The distribution day is a highly accurate weakness signal, especially if preceded by a successful rally. A distribution day is where the large investors unload a part of their shares under the perception that the market is topping out. A distribution day is best characterized with a wide high-to-low spread and a heavy volume, but it never closes too much higher than the previous day. In addition, it usually has a small open-to-close difference, a shape known as the “doji” by candlestick experts. When you see a lot of these days in a period of modest momentum, it usually means that the trend is probably over.

Symptom 3: Failed rallies.

The last sign of a topping out market is that, after an overall head is formed, the subsequent rallies often end with a weak momentum, as demonstrated by a diminishing increase in price accompanied by a decreasing volume, and each day the close is usually away from the intraday high. This is a sign that the large investors are not very keen in buying the pullbacks.

Summary

Over his legendary career, Livermore obtained two important insights in trading: firstly, he often lost when he entered a position before a pivotal point was formed, and secondly, the big money could only be made by capturing big trends, thus he developed the discipline to avoid any personal opinion until a pivotal point appeared, as well as to hold onto his positions until he was shown the symptoms of weakness. In short, this is how Livermore traded:

1. Trend confirmation: he never trade against the trend as indicated by the reversal pivotal points.
2. Careful entry: He only entered the market when a sound breakout appears.
3. Let the winners ride: He held onto his positions until the symptoms of weakness appeared.

And you are very unlikely to be doomed in trading if you follow these rules.

Trading FX Like Jesse Livermore Traded Stocks

http://www.sfomag.com/ArticlePrint.aspx?ID=1315

March 2009
By Jamie Saettele

Jesse Livermore is widely considered to be one of the greatest stock traders of all time. On more than a few occasions, he traded a shoestring into at least a $1 million fortune. It is said that the 1929 stock market crash was the pinnacle of his career, when he shorted stocks and made more than $100 million. Somehow though, he ended up broke and committing suicide in 1940.

His demise is most likely because he did not follow his own trading rules. Still, when Livermore followed those rules, his trading success was unparalleled.

The keys to his trading are not limited to the stock market. Foreign exchange traders can apply Livermore’s techniques to gain an edge in their trading as well.

SOME BACKGROUND

In modern trading jargon, Livermore would be classified as a swing or position trader. In Edwin Lefevre’s 1923 classic trading book Reminiscences of a Stock Operator, Livermore explains that the common

thought of the day is “you never grow poor taking profits. No, you don’t. But neither do you grow rich taking a four-point profit in a bull market.” He would build his position gradually, putting himself in place to catch the meat of the trend.

Livermore was a speculator who would pick his battles more than a trader jumping in and out of the market everyday. He thought that trying to pick tops and bottoms was for fools, but he often found himself buying close to bottoms and selling close to tops as a result of his trading strategy.

In Jesse Livermore: World’s Greatest Stock Trader, author Richard Smitten writes in the guise of Livermore that “I always wanted to trade along the line of least resistance, so I was generally moving along with the crowd, the herd, most of the time … I was always hunting for the clues to the change. So I was always ready to separate myself from the popular thinking, the group thinking, and go the opposite way. These major changes in trends were hard to catch, but I did not want to ride the sled downhill with the crowd, unless I had sold stocks short.”

PIVOTAL POINTS

Livermore’s strategy was based on what he termed “pivotal points.” Most traders today are aware of pivot points, and many traders use some form of pivot points (of which there are too many to count) in order to identify support and resistance, which aids in entering and exiting trades. To my knowledge, Livermore was the first trader to refer to a pivot concept. If he was not the first, then he certainly was one of the first.

Livermore defined pivotal points as days that contained heavy volume. After a prolonged move, significantly increased volume was a key signal to him that the market was at the end of its major move. Rather than exit his position instantly, he would wait for the market to roll over and confirm that what he saw was what he referred to as a reversal pivotal point. At the end of a trend, a reversal pivotal point may be referred to today as a blow-off top or a panic bottom.

However, not all pivotal points lead to reversals. Heavy volume is often present not just at the end of a major move but also toward the middle of a trend. Take a look at a stock chart to see for yourself. If, for example, heavy volume occurs and the market in question does not roll over right away (or bounce right away), then a continuation pivot point may have occurred. When a continuation pivot point occurred, Livermore added to or even initiated his position.

ADAPTING TO THE FX MARKET

You are probably wondering how it is possible to apply Livermore’s trading tactics, pivotal points, to the FX market. Volume is required in order to identify pivotal points in the way that Livermore did. Because the FX market does not trade through a centralized exchange, no indication of volume is available. It is, therefore, impossible to trade FX in the way that Livermore traded stocks, right?

STRATEGY IN ACTION

Figure 1 reveals the Dow Jones Industrial Average (DJIA) from 1929 to 1933. The top indicator (red) is volume, and the bottom indicator (black) is the one-day range (this is simply a one-day average true range, or ATR). To the naked eye, a strong relationship exists between the two indicators.

Of course, the naked eye can be deceiving. As humans, we often see what we want to see. Statistics are required to back up our assumption. If you export the DJIA price and volume data into Microsoft Excel and perform a correlation (correl) test with daily volume and one-day ATR as the two arrays, you will find that the correlation coefficient is 79 percent—a high correlation. I ran this test with daily data from 1920 until November 2008.

Intuitively, it makes sense that the day’s volume and range would exhibit a strong relationship. If more prices are being hit, then more orders should be executed. A strong enough relationship exists in order for FX traders to use one-day ATR in order to approximate the appearance of a volume indicator. Simply plot a one-period ATR on your chart and identify the “spikes” in it. These are essentially equivalent to volume spikes (see sidebar online with this article).

In Figure 2, I have plotted the sterling/dollar (GBP/USD) daily chart and one-day ATR. I have also plotted the function that paints the bar red when one-day ATR reaches a 200-day high. (The input can be changed, of course. A smaller number will produce more pivotal points.) A pivotal point (200-day high) was made Aug. 17, 2007. If price would have dropped below that day’s low, then that day would have been defined as a bearish pivotal point. However, the day’s low was never breached and the Aug. 17 high was broken a few days later, confirming the bullish trend.

Another pivotal point occurs Sept. 28, and the GBP/USD shoots higher after breaking that day’s high a few weeks later.

A pivotal point is made Nov. 12, but price breaks to the downside this time, confirming that it is time to trade from the downside going forward. As long as price is below the high of that pivotal point, the trend is considered down. The high of that pivotal point was never breached.

A continuation pivotal point is made Aug. 13, 2008, at about the halfway point of the 2.0156 to 1.7442 decline (not shown is the reversal pivotal point that occurred in September and led to a more than 1,000-pip rally in less than a month).

Figure 3 shows the U.S. dollar/Canadian dollar (USD/CAD) daily chart with pivotal points. The rules are applied just as they were with the GBP/USD. The largest one-day ATR during the past 200 days is identified. Whichever way price breaks confirms the pivotal point as either bullish or bearish (and sometimes specifically reversal or continuation).

A false pivotal point shows up, however. On June 29, 2007, the USD/CAD appeared to have made a continuation pivotal point (bearish in this case). After falling below the low a week later, price continues to fall but reverses July 25. The high of the July 29 pivotal point is exceeded, rendering that point useless. The next opportunity presents itself less than a month later, though.

PIVOTAL POINT REVIEW

1. Identify the largest one-period ATR over X number of periods

2. If price exceeds the high of the pivotal point, then trade long. If price exceeds the low of the pivotal point, then trade short.

3. If both the high and low of the pivotal point are broken, then the point in question is no longer a pivotal point.

Experiment with different timeframes and look-back periods. Ideas include a 52-period look back on a weekly chart, and a 24-period look back on an hourly chart.

TIMING AND MONEY MANAGEMENT

One of the more famous quotes from Reminiscences of a Stock Operator: “It never was my thinking that made the big money for me. It always was my sitting.” Many read this quote and assume that Livermore meant that he lets the position ride in order to catch the big move. This is true, but there is a more important interpretation from the same book: “No man can always have adequate reasons for buying and selling.” In other words, there are times when the correct trade is no trade.

Nothing is wrong with sitting in cash. Many otherwise profitable traders fail due to overtrading. In this sense, the pivotal point is not just a timing technique. Waiting for a pivotal point to form also serves as a money management device by discouraging overtrading.

During Livermore’s success as a speculator, margins for stocks were no more than 10 percent. In other words, a trader need only put up one-tenth of the value of the investment (10-to-1 leverage). The low margin requirement was probably one of the reasons that Livermore focused so much on timing. In this respect, the stock market that Livermore traded in the early 20th century is similar to the FX market today (where margins are significantly lower than even 10 percent).

Smitten wrote in his book from the perspective of Livermore that “timing was everything to a speculator. It was never if a stock was going to move; it was when a stock was going to move up or down.” This seems quite obvious, but many traders I see pay little attention to when the market might move. It seems to be common practice to enter, long or short, and wait for the move to play out. The market may move sideways for some time before moving in the expected direction. By the time the break occurs, conditions may have changed and the break may be in the opposite direction.

Besides, it is not sensible always to be exposed to market risk. Rather, wait for a pivotal point to form before risking capital.

USING THESE TOOLS

A quote from Lefevre’s book wraps it up: “But in actual practice a man has to guard against many things, and most of all against himself—that is, against human nature.”

Trading in the way that Jesse Livermore did offers many benefits. Among the most important is the way in which pivotal points discourage overtrading. Overtrading is a detriment often overlooked by traders wondering where they went wrong.

Another benefit of trading with pivotal points as I’ve described here is that you always know where you are wrong. A stop is always placed on the other side of the pivotal point. Not overtrading and always knowing where the stop should be placed help immensely in controlling the human impulses that so often result in mistakes.

Not controlling his human impulses is what ultimately did in Livermore. When he was able to follow his rules and stay objective about the market, he was one of the greatest stock (and commodity) speculators of all time. I hope that this look into his trading tactics help you improve your FX trading.

Jamie Saettele is senior currency strategist at Forex Capital Markets LLC in New York and author of Sentiment in the Forex Market. His technical strategy is published daily at DailyFX.com. Saettele is an active currency trader employing a discretionary approach to the FX market.

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DIY: IDENTIFY PIVOTAL POINTS

In order to identify pivotal points more precisely, identify the largest one-period (five-minute, 60-minute, daily, weekly, etc.) average true range (ATR) during X number of periods (24 hours, 21 days, 200 days, etc.).

You can do this in Microsoft Excel with either a max() or percentrank() function. If the max() function returns the current period ATR, then you have a pivotal point. Similarly, if the current percentrank() reading is 100 percent, then you have a pivotal point.

In TradeStation, use the paint bar function to identify with colored bars (I use red) the largest one-period ATR in X number of periods.

In EasyLanguage:

• input: Length(200);

• var: atr(0);

• atr = avgtruerange(1);

• if atr = highest(atr, Length) then

begin

PlotPaintBar(High, Low, “PivotalPoint”, Red);

end;

The Most Important Rule for Buying and Selling

http://www.selfgrowth.com/articles/the-most-important-rule-for-buying-and-selling
By Victor Chan Wai-To

What is the most important trick for buying and selling stocks? If you can only learn one, then let it be this: only buy a stock when the evidence of strength presents itself, and sell only upon the symptoms of weakness, and in other times, just stay quiet.

The Wheat Campaign

The following story of Jesse Livermore, one of the greatest traders ever, illustrates the point. One day, when Livermore was having lunch with his friends, one of them asked Livermore about a recent trade he made in the wheat market, so Livermore entertained them with his story and said:

“I just felt the demand for wheat in America was underestimated and the price was going to rise. I waited for what I call my pivotal point and stepped in and bought five million bushels of wheat, about seven million dollars worth.

“I watched the market closely after the purchase. It lagged. It was a dull market, but it never declined below where I bought it. Then one morning the market started upward, and after a few days the rise consolidated, forming another of my pivotal points. It lay around in there for a little while, and then one day it popped out on the upside with heavy volume.”

Livermore took it as a good signal and put in an order for another five million bushels. The price kept getting higher and higher and Livermore was very happy, because it was evident that the market was very bullish at that time. The trend roared strong and the price rose steadily for several months in Livermore’s favor. He finally booked a profit of $2,500,000 when the price was 25 cents above his average.

It looked like that it was a successful trade, but instead Livermore commented on his decision, “This was a bad mistake.” His friends were puzzled.

“How the hell could it be a bad mistake to make a profit of two and a half million dollars?” asked one of his friends.

Livermore explained that his mistake was that the wheat futures market had shown no signs of weakness when he sold it. “Simple. Why was I afraid of losing the track’s money? When I sold, I was simply acting out of fear. I was in too big a hurry to convert a paper profit into a cash profit. I had no other reason for selling out that wheat, except that I was afraid to lose the profit I had made,” said Livermore, who realized he had made a great mistake of not having the courage to play the deal out to the end until he got a real definitive sell signal.

“So?”

“I reentered the market and went back at an average price 25 cents higher than where I had sold out my original position. It rose another 30 cents, and then it gave a danger signal, a real strong danger signal. I sold out near the high of $2.06 a bushel. About a week later, it sold at $1.77 a bushel.”

Livermore finished the story with the conclusion that the reason he sold the first time was simply a lack of courage, whereas the second time was different. “The next time I sold the wheat it was different; I could see definite symptoms of weakness. It gave the clues, the hints, the telltale signs of topping out. The tape always gives plenty of warning time for the savvy speculator to heed,” said Livermore.

Think Right and Sit Tight

You must have to courage to play along until the signs of weakness appear. This is the most important lesson that a trader can learn which, many years later, was emphasized by the great trader again in his biography with this famous quote:

“After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine – that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.”

It is a very important piece of the puzzle, but even seemingly easy at first glance, anyone who has ever tried to put it into practice would find it extremely difficult. Just as the first time Livermore sold in the above story, the discipline of a trader is usually overtaken by his fear of losing when his trade is in profit. It demonstrates a strange human behavior that a trader is very impatient with a profitable trade but almost always falls in love with a losing trade. As a result, a trader usually just loses control, acts on his impulsive feeling and forgets this important rule altogether.

Stick to Your Method

How can a trader tackle this problem? Former US trading champion and market analyst Robert Prechter believed that the only solution is to have the discipline to stick to your method. “To win the game, make sure that you understand why you’re in it. The big moves in markets only come once or twice a year. Those are the ones which will pay you for all the work, fear, sweat and aggravation of the previous eleven months or even eleven years. Don’t miss them for reasons other than those required by your objectively defined method,” he said.

In all, develop your own method for recognizing strengths and weaknesses in a market, and acquire the discipline to stick to the marvelous rule of buying only on strengths and selling only on weaknesses, or else just sit tight and do nothing. If you are able to do this, you will not be very far away from the promised land of speculative wealth.