Essential qualities of a speculator

Via the Tischendorf Letter...

Dickson G. Watts was the president of the New York Cotton Exchange from 1878 to 1880. His list of ‘Essential Qualities of the Speculator’ and ‘Laws Absolute” show the timeless value of his insight:

1. Self-Reliance. A man must think for himself, must follow his own convictions. George MacDonald says: “A man cannot have another man’s ideas any more than he can another man’s soul or another man’s body.” Self-trust is the foundation of successful effort.

2. Judgment. That equipoise, that nice adjustment of the faculties one to the other, which is called good judgment, is an essential to the speculator.

3. Courage. That is, confidence to act on the decisions of the mind. In speculation there is value in Mirabeau’s dictum: “Be bold, still be bold; always be bold.”

4. Prudence. The power of measuring the danger, together with a certain alertness and watchfulness, is very important. There should be a balance of these two, Prudence and Courage; Prudence in contemplation, Courage in execution. Lord Bacon says: “In meditation all dangers should be seen; in execution one, unless very formidable.” Connected with these qualities, properly an outgrowth of them, is a third, viz: promptness. The mind convinced, the act should follow. In the words of Macbeth; “Henceforth the very firstlings of my heart shall be the firstlings of my hand.” Think, act, promptly.

5. Pliability. The ability to change an opinion, the power of revision. “He who observes,” says Emerson, “and observes again, is always formidable.” The qualifications named are necessary to the makeup of a speculator, but they must be in well-balanced combination. A deficiency or an overplus of one quality will destroy the effectiveness of all. The possession of such faculties, in a proper adjustment is, of course, uncommon. In speculation, as in life, few succeed, many fail.

These are his ‘Laws Absolute’:

1. Never Overtrade. To take an interest larger than the capital justifies is to invite disaster. With such an interest a fluctuation in the market unnerves the operator, and his judgment becomes worthless.

2. Never “Double Up”; that is, never completely and at once reverse a position. Being “long,” for instance, do not “sell out” and go as much “short.” This may occasionally succeed, but is very hazardous, for should the market begin again to advance, the mind reverts to its original opinion and the speculator “covers up” and “goes long” again. Should this last change be wrong, complete demoralization ensues. The change in the original position should have been made moderately, cautiously, thus keeping the judgment clear and preserving the balance of the mind.

3. “Run Quickly,” or not at all; that is to say, act promptly at the first approach of danger, but failing to do this until others see the danger, hold on or close out part of the “interest.”

4. Another rule is, when doubtful, reduce the amount of the interest; for either the mind is not satisfied with the position taken, or the interest is too large for safety. One man told another that he could not sleep on account of his position in the market; his friend judiciously and laconically replied: “Sell down to a sleeping point.”

The Tao of PazzoMundo

Been meaning to jot these down for w a while. Think I'll make this a permanent post - add (or subtract) to it as ideas occur to me...

1) Research - never enter a position on a whim.

If you can't point to the exact reasons for a position, then why be in it?

2) Risk - never bet the house.

The 'chip away' strategy is the trader's variation on compound interest. Lotsa small wins will add up - without the pin risk of a single lottery play.

3) Time - time is money.

Know the timeframe before entering a position. Is it a trade or investment? If its a trade - play to that timeframe - be patient, don't rush it - but if it doesn't meet the objective in its allotted time, close it out.

4) Sentiment - bet against the market at extremes.

The simple question should always be 'where are the stops'? If the indicators suggest the market is all one way - then the probabilities lie with the contrary position.

Trading Rules - CXO Advisory

I love this post from CXO Advisory - a summary of their 'Eight Simple Rules from Financial Markets Research' follows...

#1. Broad financial market hypotheses explain what we have seen rather than predict what we will see.

#2. The more sources you consult, the less likely you are to be wrong, or right. The average of all opinions is approximately no opinion.

#3. If you track enough indicators, you can come to any conclusion you want.

#4. Short-term indicators offer returns that are small compared to variability. Noise swamps the signal.

#5. Some long-term indicators offer returns that are large compared to variability. It takes a patient lifetime with just a few trades to capture these returns, as a triumph of optimism.

#6. Sentiment indicators lag the market. Most people invest in the past.

#7. It will take 100 years to verify reliably the forecasting accuracy of your favorite apocalyptic oracle.

#8. The [fill in the blank] effect tends to disappear when researchers announce its existence.

Asset allocation - introducing "Hybrid Portfolio Theory"

Interesting article out from the  Venture Populist on what they term as Hybrid Portfolio Theory - forget about the name, but the content is worth reflecting on.

In short, they suggest heavily weighting a portfolio (something like 75% to 90% of assets) towards capital protection, liquidity and income - being treasury bills or the equivalent  - with the balance invested in assets with a high potential for capital appreciation - venture capital, private equity, emerging listed companies, and hedge fund type strategies.

The rationale is primarily based on the poor relative performance of equities as an asset class versus long dated treasuries - both on an absolute basis and on risk adjusted returns.  They conclude that the risk premium for holding equities just doesn't actually exist.

One line in particularly tweeked my aging synapses..."I refer to it  as Hybrid Portfolio Theory (HPT) and could safely say that less than one percent of advisors have contemplated, let alone implemented such a methodology in their practice…despite its proven efficacy and how well it resonates with high-net-worth investors."

In my experience, it is true that high-net-worth investors adopt this kind of strategy.  Variations on a theme exist as you'd expect given we are all individuals with different stories to tell, but generally if someone has significant wealth accumulated they tend to segregate their wealth into these two risk classes.  The pattern I came across was that risk capital is typically confined to the business - seeking to generate returns of at least 20% year in year out - while capital that has been released or realised from the business is parked in bank bills.  This was the same whether the individual was a property developer, liquor retailer or internet guru.

Come to think of it, this is the same investment model that an insurance company will 'typically' adopt (there will always be an AIG or HIH or FAI to muck things up).  QBE's investment parameters are almost identical (95% in highly liquid, high quality credit with average duration of 6 months - with the balance in equities).  

So what is the conclusion?

I'm open to the idea that capital should largely be protected from the vagaries of the equities market.  So having a strong tilt towards income, liquidity and capital protection makes sense.

Also, I agree with their skepticism that equities as an asset class will simply outperform.  Once again it has been made clear by this latest stock market seraglio that most companies are managed by self interested and less than inspiring individuals.  Our task then is to find those few companies that have growing business models that are well managed by quality individuals.  They are likely to be companies that will generate returns of 20% per annum.  They are out there, its a 'wood for the trees thing' - and the good thing in this market is that the rotten trees are all falling over.

Dennis Gartman's trading rules

I was a happy reader of the various Book of Lists that were around in my childhood (I was just reminiscing about one such list tonight - the top ten recorded accounts of spontaneous combustion...that is the smouldering shoes variety).  In my continuing homage to their memory, here is Dennis Gartman's 22 trading rules...

1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. "Markets can remain illogical longer than you or I can remain solvent". Illogic often reigns and markets are enormously inefficient despite what the academics believe.

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable.

21. There is never just one cockroach!

22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Dow Theory

Basic principle is that the index is "an average that discounts everything" - builds all the market's moods, information and supply/demand dynamics into its price.  

The market then has two states - the bull and the bear - each of which has three phases

1) Bull market 

(a) reviving confidence - the index starts to move higher.  This occurs where

- there is fundamental undervaluation (low P/E ratio)

- all news is bad

- public is absent from the market

- market may ignore bad news

- looks like a normal bear market rally

- there is general disbelief and then increasing fear of missing out

- its a rally based on anticipation

(b) Increased earnings - the initial rally is confirmed.  This is the longest and safest to trade and occurs when:

- fundamental values return to normal

- earnings increases emerge

- good news announced

- each correction ends higher

- sector rotation to growth oriented stocks

- increasing employment

(c) Rampart speculation - the market takes off under the 'new' paradigm.  This occurs when:

- increased price volatility

- significant fundamental overvaluation

- there are a smorgasbord of new IPO's and capital raisings

- the public enters the market and day traders emerge

- media coverage increases

- market regulation relaxed

- market is driven by a few stocks

2) Then there are the three phases of the Bear market.

(a) Abandonment of hopes - the first and quick sell-off.

- fundamental valuations still high

- market may ignore good news

- interest rates increase

- maybe other shock news

- IPO's fail then abandoned

- volume falls away - indicates buying is done or is sustained only by deleveraging

- public may see the correction as a buying opportunity

- public may also panic

(b) Decreased earnings - the long slow realisation that its not going to get better quickly.

- fundamental valuations return to near normal

- market ignores good news

- earnings decreases announced

- No IPO's

- Sharp sucker rallies followed by new lows

- Public lose interest

- former market leaders fail

(c) Distressed selling - the tail end of the bear market sell-off - it doesn't have to be quick or in high volume 

- significant fundamental undervaluation

- unemployment peaks

- bad news discounted

- no public participation except for forced liquidations

- specialist media disappear

  - many bankruptcies and failures

Phoenix stocks - identifying stocks to buy

Looking for candidates to buy, how about these criteria?

1) A growing business - business with wide and growing opportunities

2) Earnings certainty - a sustainable competitive advantage - strong pricing power

3) Mispriced opportunity - misunderstood business situation

4) Quality management/board - with a track record and significant insider or founder ownership and buying

5) Strong returns on invested capital and ROE

6) Solid balance sheet - low debt and ideally not a capital intensive business

7) Strong, stable cashflows - cashflows as good or better than net income

8) Buying back shares - EPS accretive

9) Small market capitalisation - brokers only like companies that need to pay them fees, small is beautiful but unloved

10) Attractive valuation - sustainable P/E below 10x and preferably trading below NTA

Tuen Draaisma - Buy signals for an end of the bear

Tuen Daaisma (chief strategist at Morgan Stanley) signals to look for:

1) Valuations low - Shiller P/E ~10x and Price to NTA ~30%

2) Earnings at cyclical low - ROE below the long run average of 12.8%

2) Fixed income markets rallying while equity market is still heading lower

3) Copper price is bottoming out

4) Auto sales improving (or at least getting less bad)

5) Inventories very low - US housing inventories of unsold homes under 8 months

6) Banks balance sheets repaired and ready for business - as measured by senior loan officer survey being greater then negative 20% (ie. not still undergoing credit contraction)

Tuen Draaisma - Lessons from bear markets past

Tuen Draaisma is chief equity strategist at Morgan Stanley (with good form on reading the markets) - his lessons from bear markets past...

1) Valuations get very low indeed 

(a) Shiller PE to 10x

(b) Price to NTA of 30%

2) Equities become cheap slowly - average duration of a bear market is 14 years

3) Sentiment is not hugely negative at the bottom - no climactic final sell-off on high volumes, in fact the opposite final slump more likely on lower and lower volumes - then subsequently higher volumes at higher levels confirm bear market is over

4) Patience - equities do trough during recessions but they do not anticipate recovery by 6-9 mths - that is there is not much anticipation of the upturn in prices prior to the end of the bear market

5) Times have changed but the rules have not

6) Don't fight the Fed - when the Fed cuts rates and equities are cheap you should buy - but wait for the signal - there has been no signal yet...

7) Fixed interest markets have given some good warning signals - government and corporate bonds rally on average 10 and 4 months before equities reach their final trough...

Seven Sell Signals

Trade parameters

1) Protective stop - set to protect against sustaining a large loss at the time of entering a position

2) Price targets - set to lock in profits 

Change in trend signals

3) Gaps against the prevailing trend - something has broken - is it time to get out?

4) Trailing stops - breaking trend of higher highs 

5) Moving average crossovers - typically confirm changes in trends

6) Key reversal - an inside-out day where a new high (low) is made yet close below (above) the previous day's range

Time is money 

6) Time based stops

More folkloric wisdom

From David Rosenberg,

1) In order for an economic forecast to be relevant, it must be combined with a market call.

2) Never be a slave to the data – they are no substitute for astute observation of the big picture.

3) The consensus rarely gets it right and almost always errs on the side of optimism – except at the bottom.

4) Fall in love with your partner, not your forecast.

5) No two cycles are ever the same.

6) Never hide behind your model.

7) Always seek out corroborating evidence.

8) Have respect for what the markets are telling you.

9) Be constantly aware with your forecast horizon – many clients live in the short run.

10) Of all the market forecasters, Mr. Bond gets it right most often.

11) Highlight the risks to your forecasts.

12) Get the US consumer right and everything else will take care of itself.

13) Expansions are more fun than recessions (straight from Bob Farrell's quiver!).

Trading Rules - Bob Farrell

From the legendary Wall Street equity strategist whose career spanned 1950's to 1990's...ten lessons on the markets

1) Mkts tend to return to the mean over time
2) Excesses in one direction will lead to an opposite excess in the other direction
3) There are no new eras – excesses are never permanent
4) Exponential rapidly rising or falling markets usually go further than you think, but the do no correct by going sideways
5) The public buys the most at the top and the least at the bottom
6) Fear and greed are stronger than long term resolve
7) Markets are strongest when they are broad and weakest when they are narrow to a handful of bluechip names
8) Bear markets have three stages – sharp down, reflexive rebound, and drawn out fundamental downtrend
9) When all the experts and forecasts agree – something else is going to happen
10) Bull markets are more fun than bear markets