What Is Not Seen

How to trade in stocks (1940) was the last achievement of Jesse Livermore (1877-1940). The story of Livermore, is perhaps best captured in the classic, 1923 book: Reminiscences of a stock operator, by journalist Edwin Lefèvre.

Born in New York, the colorful stock market speculator was famous for making millions on the stock market, especially from shorting the market in the great crash of 1929. In How to trade in stocks, Livermore lays out his ideas on speculation, after 40 years dedicated studies of the world’s stock markets.

Livermore was a stock market speculator. He saw speculation as any other business there were. Where success did not come easy, and required hard work.

According to Livermore speculation can be seen as:

the most uniformly fascinating game in the world. But it is not a game for the stupid, the mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.

For Livermore speculation was nothing more than anticipating future movement in prices. The applicability of this idea rests upon his theory that nothing new ever happens in speculation. Even if some variations occurred, he believed that similar price patterns, repeated themself over and over.

As soon as you familiarize yourself with the actions of the past, you will be able to anticipate and act correctly and profitably upon forthcoming movements

Livermore divided stock movements into two separate kinds, either stocks behaving “normally”, or they behaved “abnormally”. Never be afraid of normal movements, he maintained. But when abnormal stock movements occur, it is time to get out! When placing a bet on a single stock, the Livermore market method would urge you to close it, should the stock not behave as you expected. On the other hand, should the stock move in tandem with your bet, one should increase the bet size.

A vital point in Livermore’s strategy was to identify certain pivotal point in prices. When a stock reached this point, he would make a move. For example, when a stock for the first time moved to 100, he would buy it, since this often represented a psychological barrier, pushing prices further.

Throughout the book, Livermore provides lots of recommendations and advises:

“Never sell a stock, because it seems high priced”

“Never buy a stock because it has a big decline from its previous high”

“Never average losses”

However, the key element in the Livermore method is bookkeeping. By constantly recording specific stock prices in a certain fashion, Livermore had created a method that allowed him to view large amounts of information, in a structured fashion, allowing him to spot different trends and price patterns.

Finally, from the book Reminiscences of a stock operator, perhaps the most important lesson Livermore left us, was that:

there is nothing like losing all you have in the world for teaching you what not to do. And when you learn what not to do in order not to lose money, you begin to learn what to do in order to win. Did you get that? You begin to learn!.

And Livermore had first hand experience from learning by his own mistake, as he lost his complete fortune, twice.

Sadly Jesse Livermore committed suicide the same year the first edition of this book was published.

If you are interested in how he manage his bookkeeping, I recommend that you pick up the book and chapter IX: Explanatory rules, where he in detail explain the structure. The complete 1940 book can be found in PDF, here.

My good friend Stefan Karlsson has a great post on current stock market valuations, where he cites my recent post on Stock market corrections. From an earning perspective, Stefan refers to the historical high levels of earnings relative to stock market prices, that we see today.

Take a look at this chart, which show the same chart as in Gregory Mankiw’s original post: the 10 year P/E moving average, together with the Dow Jones Industrial Average, over the last 100 years!

This chart can also be seen in Fari Hamzei’s book: Master Traders, and found on Tuttle Asset Management LLC website.

We see that over the last 100 years, the Dow Jones Index has experienced 3 major consolidation periods, with each lasted on average about 16 years. Historically, the length of the these periods have been in direct relationship to the length of the preceding bull markets. Before each consolidation period ended, the 10 year P/E ratio had fallen below 10. Not until the 10 year P/E once agian reached higher levels, above 10, would a new bull market begin.

The latest bull market lasted more than 17 years, from Oct. 1982 to Jan. 2000. Currently, the 10 P/E has been decreasing for 5 years, ever since the dot-com crash. With current levels above 25, it should be safe to say that the stock market, also from a fundamental perspective, is over valued. Do the math!

The hottest topic of today is definitely inflation. The effects from inflation can be seen everywhere. Recently we saw oil prices, surge to over $134 per barrel.

Leaving fundamental factors aside, inflation has contributed to massive gains in commodity prices during the last year. Even deflated government figures like CPI and PPI have begun to show big increases, as monetary inflation has filtered through the economy, pushing over all prices higher.

The Austrian definition of inflation regards monetary inflation. Simply, If the money supply grows, there is inflation. One result from monetary inflation is price inflation, or increasing nominal prices on goods. The price inflation we see today is therefore the result from monetary inflation that happened in the past. Today, we experience the accumulated effect from monetary inflation, that occurred many years ago.

An interesting question is whether we should expect this historical inflationary buildup to continue to push prices higher, as we speak today? Or, as some people argue, that we should expect prices, or price inflation to moderate as the economy slows.

The problems involved with trying to measure statistically, the effect from monetary inflation on for example PPI, is evident. First, there is no “rule” determining how long time it takes for monetary inflation to show up in prices. Second, the effects from monetary infllation on prices is asymmetrical. Third, monetary inflation tends to accumulate over time, making the effects larger when they finally hit the economy. And fourth, not all monetary inflation show up in statistical measures like CPI and PPI.

With these problems in mind, I have tried to create a rough estimate for future price inflation, given the current monetary inflation we can observe. I have looked at the percentage yearly change in money supply, here measured by MZM (Money with zero maturity), and the percentage yearly change in PPI: All commodities, trying to map the changes in MZM to the apropriate effects in the PPI. The red line signifies PPI and the blue line MZM. Number 1 is intended to map on A, and 2 on B, and so on.

Even if this approach is very basic, I belive it can serve as a rough guide for what lies ahead.

Looking at 8 and H, we see something interesting. When the rate of monetary inflation slowed after the tech-boom crash in 2001, PPI didn’t slow at all. Historically a decrease in MZM has followed by a similar decrease in PPI, as we can see for example with 3 and C.

Ever since late 2001, price inflation has grown significantly faster than than it did, any time since the 80’s. This has happened in an environment where MZM has been decreasing. One explanation for this buildup in PPI, is precisely the historical increases of the money supply, that has been building up, and not until recently starting to puch up prices on goods.

This is supported by what happened when MZM once again picked up. After MZM had bottomed in 9, PPI quickly increase from I to new record levels.

Looking ahead, we hypothesize that the bottom I for PPI coincides with the bottom 9 for MZM, and construct a likely scenario for the development of future PPI and price inflation. The time elapsed between 9 and I is 16 months, between June 2005 and October 2006. This means that the last 16 months change in MZM does not yet show up in the PPI numbers.

According to the chart, money supply, MZM has been growing exponentially ever since 8, and currently by 16 % per year. Even if the rate of change in MZM would slow some time soon, we should still expect prices continue to increase. And even if we would see a temporary decline, the trend in PPI is clear. We are entering a period with on average higher prices, both producer prices and consumer prices.

On wednesday, oil reached over $134 per barrel, on numbers showing a decline in inventories with 5.32 million barrels. This is the biggest decline in four months. On the news, major stocks market declined.

The recent rise in crude oil is also reflected in the average retail regular gasoline price, which set a new all time high with 379.1 cent per gallon, on Maj 19.

Read the full EIA report here, or the highlights here.

On March 10, major U.S. stock market indices like S&P 500, Dow Jones Industrial Average, and Nasdaq, all reached there respective lows after the last stock market sell off. Since then, stocks have rallied, with S&P 500 up 11.94 %, Dow Jones up 10.62 % and Nasdaq up 16.57 % .

While some people seem to believe that we now are “out of the woods”, I strongly think that the economic troubles so far are only getting started.

For the stock market, we should expect a correction soon. For guidance, I turn to my favorite contrarian indicator, the Bullish Percent indicator. This indicator tells us how many percent of the underlying stocks of an index that are showing there first Point & Figures buy signal. At present, this gives us a way of gauging if stocks at given prices are over bought, and hence are likely to correct.

A reading above 70 is red alert for stocks, should they start declining. A reading below 30 in the Bullish percent is a good opportunity to buy, as only a small amount of additional money entering the market will push up prices.

Since the stock market started to increase, investors and asset managers have successively increased their exposure to stocks. This was captured by the bullish percent. Looking at Bullish percent for New York Stock Exchange, and for S&P 500, we see that the index reversed up into a column of X’s in the final weeks of March.

Now 40 days into the bear market rally, the Bullish percent indicators have all begun reaching higher levels. NYSE Bullish percent are currently showing that 58 % of the index stocks are displaying buy signals, and are still rising. S&P 500 shows that 62 % of the stocks are experiencing positive demand. Dow Jones on the other hand have recently reversed down from 66 % to 60 %. Suffice to say, current levels should start to raise some concern.

Given the present economic conditions, many managers and investors are still cautious. This can be interpreted that a Bullish percent reversal at present levels could be as serious as a reversal above 70 in the past when over all economic conditions were better.

When it comes to the Bullish percent indicators i don’t like trying to predict the predictors. As likely as a reversal, more capital may enter the stock market pushing prices and Bullish percent even higher. Personally I look at the indicator, and only afterwards take the apropriate action.

Although, should we see further gain, let say NYSE Bullish percent goes to 65 or even 70, we can expect the correction to be more severe and longer lasting, when it eventually comes.

Today, The Conference Board published their so called Leading indicators, that are suppose to lead investors in the right direction where the economy is currently heading. According to the report, leading indicators increased by 0.1 % in April. This was great news if we want to believe the media. While the stock markets early got a good start, little focus, as usuall, was given to the coincident indicators. These indicators were actually flat in April, and were down 0.4 % in the latest 6 months.

They compose of, Employees on nonagricultural payrolls 0.5426 %, Personal income less transfer payments 0.1890 % Industrial production 0.1493 % and Manufacturing and trade sales 0.1191%, that is, the same indicators used by the NBER (National Bureau of Economic Research) in calling recessions. This is one of the reasons, I believe these indicators give a more accurate view of the economy than the real “leading” indicators.

Looking at the components of the coincident indicators, we get a clear picture of where the economy is heading. Non-farm payroll have lost 260 000 jobs so far during the first four months of the year. We know that manufacturing is deteriorating, according to the latest ISM reports the manufacturing sector is slowing. The only indicator, that until recently have held up is Industrial production. But the latest report, show that production fell 0.7 % in April, together with negative revisions for both March and February. Industrial production now appear to have reached its top in January this year.

A good Herald Tribune article: Money is tight, or is it? points out that the rate of credit expansion is still increasing, despite the fact that banks allegedly are tightening credit. Foremost, this can be seen in commercial and consumer loans, which have been continuously increasing the last 6 months. The reason for this gain is partially explained by companies utilizing alternative and new lines of credit.

What happened was that many companies that financed themselves through securities markets, particularly commercial paper, had paid for backup lines of credit. The banks thought few of those lines would ever be used, but suddenly many were.

Looking at the numbers, we see that the rate of change in Commercial and Industrial Loans, are 20 % higher now, than last year. Consumer credit rose 5.4 % the first quarter this year, shown in a report released Maj 7. Even if some banks probably are reluctant in approving new credit lines, they have little or no control of the already existing lines that have been fueling overall expansion since last year.

Another factor, not mentioned in the article, that cannot be stressed enough, is that a lower federal funds target rate creates additional incentive for businesses and consumers to encourage new loans, resulting in further credit expansion.

Recently, I published a post on the U.K. housing market, where I argued that house prices are going to decline in the coming years. Later I got some questions regarding the U.S. housing market, if I believed a bottom could be seen any time soon. Compared to U.K. where house prices recently started to decline, the U.S. housing market has been declining since it peaked in 2005. As I mentioned in the post, housing cycles are especially long lasting, and for the U.S. economy I belive that house prices still have a far way to go until they bottom. From the Swedish language blog, finansblogg, there is a similar image for the U.S. housing market that I showed earlier for the U.K. housing market. The image show real house prices, both Case-Schiller home prices, and average existing home prices.

The Case-Schiller index measures house prices in 20 metropolitan regions across U.S. Looking at the chart, we see that prices today is still three standard deviations above the long term average.

The reason why I belive this downturn is much more severe than earlier ones, is analogous to what I briefly explained in the post about the U.K housing slump.

Some economists are trying to estimate the cost of the current mortgage crises, unfortunately, most of them are blind to the real costs of the crises. IMF recently estimated the cost to $945b. This estimate has misled even some distinguished economist in believing that the mortgage crisis isn’t that serious. The political economist, Anthony de Jasay is one example. In his latest article “A trillion dollar “catastrophe”?” the Anglo-Hungarian economist, argues that the sub prime crises isn’t really a crises, but for the most part a zero-sum-game. In his words:

The current “crisis”, as every opinion-maker persists in calling it, is primarily […], one of loss of confidence.

and

[m]ost if not all of the trillion dollars is only a loss to one side in a zero-sum game; it is a gain to the other side. If the mortgagee lends too much on a house to the mortgagor, the latter gains what the former loses; the house itself suffers no material damage. If the mortgagee escapes the loss by having the mortgage “packaged” with many others in a “collateralised debt obligation,” that is passed on to some institutional or private buyer, it is the buyer who takes the loss if some of the mortgages in the CDO turn out to be worth less than their face value. There may be a whole chain of buyers sharing in the loss. Some in the chain may even gain.

Jasay reaches his conclusion by looking at the nature of derivatives. Since derivatives to a large extent, actually are zero-sum games, where someone’s loss is another one’s gain, he believes the effect of the crisis is limited, mostly to some redistribution effects. But as I argue, the loss from bad derivative transactions are not the only cost that needs to be considered in gauging the effect of the crises. The real costs are the opportunity costs from misallocated investments and capital.

When interest rates where held artificially low in the past, entrepreneurs got the impression that real savings in the economy had increased, fueling capital spending and investments to unsustainable levels. What we now are beginning to see is that entrepreneurs are starting to realize that they don’t have enough funds in order to finish and maintain the new productive structure, causing distress for many businesses.

According to the Austrian business cycle theory, firms far away from consumption, is hit the hardest, as their amount of malinvestments tend to be higher. Therefore, we need to watch the manufacturing sector in order to gauge the real cost from the credit crises fallout.

According to the Institute for Supply Management, the manufacturing sector has now been falling for the third consecutive month. In the April report, increasing price presure and growing inventories show clear signs of troubles down the road as profit margins for manufacturers shrink, leading to slower economic activity, and finally to higher unemployment.

In addition to ISM, the Employment situation show that, non farm employment have now been falling for the fourth consecutive month. While the headline number in the Establishment survey is -20 000, looking at the broader measure for unemployment in the House hold survey, where we include officially unemployed, the number of marginally attached workers, and the number of working part-time for economic reasons, total unemployment surged to 9.2% in April from 8.2% since last year.

A trillion dollar “loss” in derivative related assets may not be Judgement day. But the fact that the manufacturing sector is slowing and unemployment are on the rise, should result in deep concerns, also for people like Jasay.

According to economic theory, illustrated by economic data, the current credit crisis is not only a crisis, but a severe crisis. The real cost for the economy is not primarily related to derivatives, but are found in the malinvested capital. What we are now seeing in the ISM report and in the Employment situation report is a reflection of the process where capital is being liquidated. Some invested capital will be reallocated to better use. But a large part of the capital stock is fixed capital, and cannot be transformed to any other productive use. These investments will be a total waste of resources, and constitute the real unseen cost of the credit crisis.

In my review of Thomas J. Dorsey’s book: Point & Figure Charting, I wrote that technical analysis (especially Point & Figure charting) could be seen as a form of entrepreneurship in the financial sector. When betting on the stock market, technical analysis is an important tool investors use when he is trying to get the odds in his favor.

This is especially relevant in the short term, where prices tend to move according to sentiment and peoples expectations. In the medium to long term, sentiments and expectations play a much smaller part in determining the overall trend. Here, fundamentals become more important as prices tend to conform to the underlying supply and demand dynamics.

In this analysis, Austrian economics can be very beneficial. For people not familiar with Austrian economics, What every Investor should know about Austrian economics and the hard-money movement (1988 ) by Mark Skousen, is a must read. This is a beautiful little book (and perfect for weekend reading), with a very interesting theme: Austrian Economics applied to finance.

However, for people already familiar with Austrian economics, I doubt that What every Investor should know about Austrian economics and the hard-money movement will add much new insight, as it is an introduction. But, because of the scarce supply of Austrian investment books on the market, I still think this little book deserves a place in every serious investor’s personal library.

Skousen does a great job in pointing out some important features of Austrian economics that you don’t easily find in the average text book. In the part called, Followers of the Austrian School of Economics, he mentions the obvious, but often ignored fact, that one of the keys to economic growth and prosperity is a high rate of personal savings and capital formation.

The Keynesian framework provides a relevant example. Here, focus lies completely on consumption, and not on savings. This misconception has serious effects on the economy, as government consumption is believed to produce prosperity.

On Wednesday this week, we could see another example resulting from ignoring this key insight, the GDP report. GDP are supposed to measure the health of the economy for a country. Although GDP is an important number, it almost completely consists of consumption related spending. This takes focus away from what is really the driver of economic prosperity and capital formation, namely savings.

Another Austrian insight mention in the book is that government inflationary policy is responsible for the boom-bust business cycle. What Skousen is refereeing to here is the Austrian business cycle theory (ABCT), first developed by Ludwig von Mises.

In the part called How to profit from the business cycle, Skousen gives a brief overview of how he sees the business cycle. He divides the cycle into four stages: (1) The inflationary boom, (2) The credit crises, (3) Recession, and (4) Economic recovery. Depending on which stage the business cycle is experiencing, different types of assets are more suitable than other in an investors portfolio.

However, Skousen points out, as also many other Austrians do, that no one rings the bell when we go from one stage to the next. This fact has even made some people question the value of Austrian economics in practical investing.

However, It should be clear, even if Austrian economics cannot answer that question, by understanding the causal relation ship between credit expansion, inflation and the business cycle, people familiar with Austrian economics have a direct advantage over the average nonaustrian economist, in making appropriate long term investment decisions.