Trend following, Jesse Livermore and natural disasters

This is not the easiest topic to write about, but with the happenings in the US this week I feel compelled to write about trading and natural disasters.

Those of you who have read Reminiscences of a Stock Operator, Edwin Lefevre’s classic book reportedly based on Jesse Livermore, will know that ‘Larry Livingston’(Livermore) profited from shorting stocks immediately prior to the 1906 San Francisco earthquake. Initially the market held up, but Livermore was patient enough to sit in his positions, and the market finally succumbed to a sharp downdraft after a couple days.

It is a harsh but true fact of life that, out of natural disasters or other major events, there are people who seek to profit out of tragedy and the misfortune of others.

Those of you who have read my blog for a while will know that I got a short signal on the indices immediately prior to the 2011 Japanese Tsunami, and therefore was holding short positions when that particular tragedy unfurled. My positions benefited to begin with before the market formed a ‘V’ shaped reversal and moved back up, stopping me out of those short positions at a loss.

With the events that have occurred in the US as a result of Storm Sandy, I find myself in a similar position once again, in that the markets have given a short signals over the last week or two, and that the bias in my portfolio is once again on the short side.

In Michael Covel’s book Trend Following, there is a section devoted to major events that have occurred, which have significantly affected the markets, and that it was pointed out how often a trend follower was trading in the correct direction at that particular time. By definition, a trend follower would be trading in the correct direction when there is a major market specific event (such as the 1987 market crash, the dot.com bubble, the 2008 crash etc), but also more often than not when other major events occur, such as the collapse of Barings Bank, 9/11 etc.

Back to Livermore. While he started shorting stocks on a hunch prior to the earthquake, I follow the trend on the indices as a basis for whether I should be long or short stocks. Indeed, Livermore himself came to the same conclusions:

“I began to see more clearly - perhaps I should say more maturely - that since the entire list moves in accordance with the main current… Obviously the thing to do was to be bullish in a bull market and bearish in a bear market. Sounds silly, doesn’t it? But I had to grasp that general principle firmly before I saw that to put it into practice really meant to anticipate probabilities. It took me a long time to learn to trade on those lines.”

He lost his profits gained from the earthquake event later that year, convinced that the market was going to go down. However, after repeated attempts at shorting stocks, he finally got it right: “...this time I was cold-bloodedly right, not because of a hunch or from skillful reading of the tape, but as the result of my analysis of conditions affecting the stock market in general. I wasn’t guessing. I was anticipating the inevitable. It did not call for any courage to sell stocks. I simply could not see anything but lower prices, and I had to act on it, didn’t I? What else could I do?”. Again, while he pinpointed to a number of factors that would impact upon the market, I let the trend of the indices determine when my directional bias should change.

While all this potentially creates a moral dilemma when a disaster such as this takes place, the fact remains that I am in the business of seeking to profit from the market movements, be it in an up or down direction. The fact also remains that my bias was determined by the markets movements, not by seeking to profit directly from a natural disaster. I also have no positions open in any US stocks at this present time. It should also be said that there are similar events happening around the globe on a regular basis, which probably get reported on a lower scale.

I will finish this post by wishing any readers of this blog in the US (and there are plenty) that you are all safe and well, and that, if you are in the affected areas, that things can get back to somewhere near normality as soon as possible.