This weekend I was a bit under the weather. After sleeping most of Sunday away, I moved with my blanket from the bed to the couch and did a little reading from one of my favorite books in the world, "Reminiscences of a Stock Operator". If you've never read the book, it is truly a delight - a great story and a trader's Bible in the form of a fictionalized bio of one of the greatest traders ever to have lived - Jesse Livermore. Open it up to any page, and you're sure to find some interesting, valuable or both. This is exactly what happened to me last Sunday as I was pondering the fate of the Dow, which managed to trade and close above 12,000 for the first time last week.
I opened the book at random and after a few pages came across the following passage that begins on the bottom of page 125. Livermore's fictionalized character -- Larry Livingstone - is discussing the importance of trading along the line of least resistance.
Not long ago I was with a party of friends. They got to talking wheat. Some of them were bullish and others bearish. Finally they asked me what I thought. Well, I had been studying the market for some time. I knew they did not want any statistics or analyses of conditions. So I said: "If you want to make some money out of wheat, I can tell you how to do it."
They all said they did, and I told them, "If you are sure you wish to make money in wheat just you watch it. Wait. The moment it crosses $1.20, buy it and you will get a nice quick play in it!"
"Why not buy it now, at $1.14?" one of the party asked.
"Because I don't know yet that it is going up at all."
"Then why buy at $1.20? It seems a mighty high price"
"Do you wish to gamble blindly in the hope of getting a great big profit, or do you wish to speculate intelligently and get a smaller but more probable profit?"
They all said they wanted the smaller but surer profit, so I said, "Then do as I tell you." If it crosses $1.20, buy."
As I told you, I had watched it a long time. For months, it sold between $1.10, and $1.20, getting nowhere in particular. I got ready for it. Sure enough, the next day it opened at $1.20-1/2, and I bought. It went to $1.21, to $1.22, to $1.23, to $1.25 and I went with it.
Now I couldn't have told you at the time just what was going on. I didn't get any explanations about its behavior during the course of the limited fluctuations. I couldn't tell whether the breaking through the limit would be up through $1.20 or down through $1.10...
...The price went beyond the $1.20 mark. That was all the point I had and it was all I needed. I knew that when it crossed $1.20, it would be because the upward movement at last had gathered force to push it over the limit and something had to happen. In other words, by crossing $1.20, the line of least resistance of wheat prices was established. It was a different story then.
Traders will recognize the fundamental concepts of resistance, breakouts and momentum, though Livermore never mentions these terms explicitly. Furthermore, what Livermore explains about wheat transcends any specific market and applies perfectly to any market, including the Dow today: Add a couple zeros and move the decimal point, and you're talking Dow 12K.
But more important are the conceptual similarities: Wheat had been bouncing around between $1.10 and $1.20 for months. Some of his friends were bullish, others bearish, like in any market. Livermore wasn't at all sure that it was even going to break $1.20, but if it did, he knew that it would run away. Like many investors today, Livermore's friends couldn't understand the logic of buying high, thinking that $1.20 was "a mighty high price" already. Livermore bought at $1.20, and rode wheat until at least $1.25. The book does not say where he eventually cashed out but we do know that Livermore was a trader, equally willing to go long or short, and not a "marry your position, buy and hold" investor. We can be certain that he eventually cashed out his wheat position at a handsome profit.
Finally, he says that he at the time, he "couldn't have told [us] just what was going on." All he knew is that it was going up, so he was buying! This is no different from the trend traders or momentum players today, who are pushing up the Dow and participating in the current rally.
A Profitable Sucker's Rally
How far will the Dow go, and how will it unwind? That is impossible to say, but it is certainly a profitable rally for those who know what they're doing, and a sucker's rally for those who don't. Recently I was out to dinner with some friends, and one of them commented that while the Dow was making new highs, his stocks were not. I pointed out that that is to be expected because this is a very narrow rally. In the Dow's Phony New High, I noted that even though the index itself is making new highs, most of its component stocks are not.
What should he do, my friend asked me. Should he switch his funds? What stocks should he buy?
As if I knew
This rally in the Dow is clearly making novice investors nervous - nervous because they feel they're being left behind. This is the difference between the novice and the pro. The pros (like Livermore, if he were with us today), are pushing this market up and the novices are awestruck on the sidelines. After seeing a few more days like we had today, with 100+ point days of gains, the novices will be convinced that this rally is for real, and will be falling all over themselves to get in on a piece of the action. Which is precisely what the pros will let them have - a piece of the action! Livermore might have ridden wheat up to $1.25, but you can bet he liquidated into the rally as the suckers got on board.
I tried in vain to explain all of this to my friend, and that he should sell all of his stocks and buy CDs, which he could not believe. He wasn't going to settle for 5% -- not when the Dow is making new highs! He didn't want to hear anything of the sort, and so somehow changed the subject. Not many people are willing to listen to things they don't want to hear. Had he been willing to listen, I would have told him what I am about to tell you: The current divergence between the financial economy and the real economy is setting up the shorting opportunity of a lifetime. Most "investors" today are unfortunately not sophisticated enough to understand how to take advantage of the coming opportunity.
Shorting? Huh?
Legendary Divergence
The Dow traded and closed above 12,000 for the first time last week. In spite of the fact it is extremely overbought and trader optimism is at record, nothing can hold it back: Not Ford's announcement of a $5.8 billion loss today, not Dow Component Caterpillar (CAT)'s 14% drop on Friday, (biggest drop since 1987) not the slowing housing market, nor any number of factors pointing to a slowing economy. It is as though we've entered an alternate 1984 universe in which all bad news is good news. As far as the market goes, the line of least resistance has been established, and for the time being the Dow is moving up.
But nothing lasts forever. How much higher will the Dow go? I have no idea, but I do know one thing that I learned as a child: What goes up, must come down. As far as I know, that law of nature has not yet been repealed. There is an increasing divergence between what is happening in the real economy (see CAT) and what is happening in the financial economy (see the Dow). Such a divergence is not without precedent. As I pointed out in Dow 2006 vs. Nasdaq 1999, stocks can chug along quite nicely on purely technical factors to the surprise and disbelief of fundamentalists for a long, long time. Incredible gains are produced in the process for those who know what they're doing. But if the fundamentals cannot justify those prices, the market will ultimately take back those incredible gains - and those who know what they're doing can profit on the way back down!
The Shorting Opportunity of a Lifetime
In my next installment, I'll lay out the case as plainly as possible for the shorting opportunity of a lifetime, and show how you can put yourself in a position to profit from it. It will involve shorting, so only sophisticated traders -- or those willing to learn -- need tune in. If you're interested in being notified, please sign up to my free, low volume announcement list.
