Image source: Pixabay

In my opinion the greatest book ever written on trading is Reminiscences of a Stock Operator (1923) by Edwin Lefevre. Reminiscences tells the story of Jesse Livermore – by most accounts the greatest trader of all time – under the psuedonym Larry Livingston.

They say the difference between a good book and a great book is that a great book rewards regular re-reading. That is, every time you read a great book you learn new things because your own perspective has evolved and you therefore see things you didn’t the last time around. A good book, on the other hand, is best read once and then forgotten because its message can be fully absorbed the first time through. No matter how many times I read Reminiscences I continue to find new nuggets.

The two most important chapters in Reminiscences are Chapters 5 and 14. Chapter 5 features the unforgettable character of Old Partridge – “It’s a bull market you know!” – and how Jesse learned the lesson that the big money was made by riding the primary trend to capture the biggest part of the total move and not worrying about the secondary fluctuations along the way:

It was never my thinking that made the big money for me. It was always my sitting. Got that? My sitting tight…. 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 then hundreds did in the days of his ignorance.

It’s difficult to tune out all the noise about the market on CNBC, Twitter, etc… with the implicit message: “Don’t just sit there. Do something!” But nobody can catch every fluctuation in the market. If you have a position that is fundamentally sound and working, there is for the most part no reason to do anything but sit tight.

Chapter 14 is about how Jesse came back from total ruin during 1915-1917 after a number of very difficult years. From a starting stake of $50,000, Jesse made $3 million in 1916 by riding the bull as long as it was a bull and then turning bearish at the right time. How did he do it?

In 1916, the US market was ramping higher as World War I raged in Europe and the Allies needed to buy supplies from the US. Money was pouring into corporate coffers:

I was rampantly bullish in a bull market…. It was plain to everybody that the Allied purchases of all kinds of supplies here made the United States the most prosperous nation in the world.

But Jesse knew that good times don’t last forever:

I went along with the rise in 1916. I was as bullish as the next man, but of course I kept my eyes open. I knew, as everybody did, that there must be an end, and I was on the watch for warning signals.

What Jesse started to notice was that some former leaders started to rollover and did not come back. Other stocks continued to lead and push the market higher but the market was becoming thinner. This didn’t cause Jesse to turn bearish on the whole market, only on those stocks that were no longer working:

My long expected warning came to me when I noticed that, one after another, those stocks which had been the leaders of the market reacted several points from the top and – for the first time in many months – did not come back. Their race was evidently run, and that clearly necessitated a change in my trading tactics.

I did not turn bearish on the market then, because the tape didn’t tell me to do so. The end of the bull market had not come, though it was within hailing distance. Pending its arrival there was still bull money to be made. Such being the case, I merely turned bearish on the stocks which had stopped advancing and as the rest of the market had rising power behind it I both bought and sold.

In other words, Jesse didn’t flip bearish all at once but transitioned his portfolio gradually according to what the action of each stock was telling him. He went from being leveraged long to a portfolio with some longs and some shorts. Then one day the market broke and Jesse knew the time had come to flip bearish:

Then one day the entire market became quite weak and prices of all stocks began to fall. When I had a profit of at least four points in each and every one of the twelve stocks that I was short of, I knew that I was right. The tape told me it was now safe to be bearish, so I promptly doubled up.

What’s the relevance to today? This has been one of – if not the – greatest bull markets in history. We haven’t had a nasty washout since 2008-2009. The market is up almost 1000% since then. That in itself ought to be of some concern and cause one to be on the lookout for signs. And I believe there are some signs….

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Once concern is that the powerful rally off the April lows is starting to thin out. The Mag 7 stocks that make up ~30% of the S&P 500 continue to pull the market higher while the rest of the market treads water. You can see this in the chart above in which QQQ continues to move higher while RSP – Equal Weight S&P – fails to make any progress. Apple pulled the market higher the last three days of last week after CEO Tim Cook made a pilgrimage to Washington to pay homage to King Trump. But RSP flat lined.

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In an excellent interview on CNBC’s Closing Bell on Friday, Technician Jeff de Graaf referenced this bifurcated market. While he’s still bullish on the overall market, there are signs to him that things are at least exhausted in the short term. Some stocks – like Chipotle (CMG), Salesforce (CRM) and Eli Lilly (LLY) – appear to have run their race.

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Another concern I have is inflation. While many seem to believe that is behind us, commodity prices suggest it’s still a problem. The market is pricing in an 89% chance of a 25 point rate cut by the Fed on September 17. Certainly President Trump is putting a lot of pressure on Fed Chair Powell. But I wonder if cutting now won’t backfire and cause long rates to rise rather than fall as investors continue to price in persistent inflation. A move above 5% in the 30 year treasury would cause concern in the market in my opinion.

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On a shorter term framework, while the market rallied nicely last week, it failed the first time it tried to break above 6400. I expect the market to open higher on Monday and test this level once again. The reaction will be telling in my opinion. I have no bias but another failure to hold above 6400 would suggest to me that the market is exhausted – at least for the moment. A break below 6200 would confirm at least a short term top.

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