Notes from Invest Like the Best: Jesse Livermore

Link: http://investorfieldguide.com/livermore/

About Jesse: Jesse Livermore is a pseudonym for the financial blogger behind philosophicaleconomics.com.

3 Methods for Drawing Meaningful Inference

1. Intuition
   • Benefit: Low cost and readily accessible
   • Costs
     • Downside is noisy especially in ‘wicked’ learning environments
     • Not transparent
   • Traders are high in ‘cognitive reflection’ and stronger intuition
     • Careful deliberation is a hallmark. Studies have shown that people who take too long or too little to decide do worse.
     • Intuition is necessary to pull triggers, but deciding too quickly without careful deliberation leads to poorer inference
2. Analysis

• • Benefits
    • Don’t need to gather data
    • A model of how something works can handle regime change by having a transparent mechanism from input to output
  • Costs
    • They are always incomplete and “so easy to be wrong”. The fact that we are prone to stories compounds the danger of analysis.
  • Using it responsibly
    • Leave margin for error
    • Validate

3. Data Analysis

• • Benefit: It is rooted in reality
  • Costs
    • Without context can be misleading
    • It is more costly
    • Requires sufficient “trial size” not just a naively high sample size
      • If your samples are highly correlated than your effective trial size is much smaller than you think. For example, all financial data drawn from a single regime or independent coin flips with an unfair coin
    • Data mining and multiple comparison
      • Patterns emerge randomly so this can occur in subtle ways, not necessarily because of fraud or nefarious incentives
        • Suggestions:
          • “Call your shot”
          • Out of sample test
          • Avoid overfitting by testing outcomes against variables that you know should not matter (for example, changing the day of the week an investing strategy occurs on should not change the result meaningfully)

Earnings are a distorted measure

• Current strict accounting standards around depreciation understate earnings relative to history
  • Old accounting standards did not adjust depreciation for inflation effectively understating inflation and overstating earnings. The market is wise and understood that earnings were overstated and assigned lower multiples during a period of excessive inflation
  • Difficult to compare multiples over time because of this change in standards
  • Depreciation is not just about physical decay of an asset but the competitiveness of an asset. E.g: Inventory of Kodak cameras become obsolete much faster than their physical decay when digital cameras emerged. Any typical depreciation formula would have vastly understated the depreciation of the assets and overestimated the book value.
• Inflation overstates earnings
  • He calculated the book value of the entire market and keeps track of retained earnings
  • The earnings being overstated means that the retained earnings that remain to actually be either re-invested or paid out to shareholders are understated once adjusted for inflation and compared to history. This means that published return on equity is likely understated because the money being re-invested is actually understated.
  • This is a known issue
    • Studied by prior economists
    • Big corps like Sears in mid-1900s argued for inflation adjusting depreciation because the overstated earnings were weakening their position in labor negotiations
• Free cash flow handles many of these distortions more accurately
  • Free cash flow “plunges” during high inflation periods validating the distortions caused by inflation on earnings
• P/IE Ratio (price to ‘integrated equity’)adjusts for all these shortcomings
  • outperforms all measures of valuation including many permutations of CAPE in correlating to future returns.
  • Highly correlated itself to CAPE and tells us that market is on the higher end of valuation which Jesse thinks is structurally justifiable
• If you want to  dig deeper, OSAM published their joint findings

Why is it plausible that markets get permanently more expensive?

1. Valuation is a function of the required rate of return to which liquidity is an input. Imagine a pre-Fed wildcat bank. You would not accept such meager real rates of return because you do not have the confidence in the liquidity of your deposit. So much of our required rates of return come down to confidence. The progress of finance has been towards greater networks levels confidence which creates downward pressure on required rates of return. The Fed put is an example of this.
2. With low growth and inflation (demographics follow Japan, Europe), volatility will be to the downside but the Fed can also act more aggressively without fear of inflation. Higher structural valuations may be reflecting this market understanding.

• Implications
  • Trend: we are seeing less trend formation and more whipsaws. Speculative but possibly due to Fed put. This has led Jesse to try to restrict his trend strategy to when it is most likely to work (ie fewer whipsaws). Historically, trend’s alpha has come from times of large market drawdowns. So he uses the trend strategy when it coincides with fundamental recession indicators. He admits the sample size is small so the research is thin and probably overfit. Best recession indicators:
    • Retail sales
    • Earnings
    • Unemployment trend
    • Housing starts
    • Industrial Production
  • He is agnostic on trend. Thinks it works but is worried about it.

Valuing the Market

• CAPE and other statistical attempts to correlate valuation with future returns suffer from small trial sizes. Markets cycles so multiple years in succession are really just a draw from the same regime (overlapping data sets)
• An alternative method of using the relative supply of assets to predict future returns. Derived from his work. My own notes on his full post are here.
• Interesting inefficiency which hints at the validity of this: There are some egregiously overpriced preferred stocks carrying low yields, are callable, and sit in inferior positions in the cap structure. The only reasonable explanation is they are in relatively short supply. It’s a “rare baseball card”. The explanation issuance of preferred stocks has declined faster than investment demand for yielding securities. In other words, the demand for asset allocation in relative proportions has not changed as much as the composition of supply has changed.
• Being biased towards flow-based explanations of pricing myself, I find this idea very compelling
• His conclusions without proof: supply matters and there are inefficiencies. The presence of the inefficiency doesn’t surprise me since constrained supply means fear of squeezes and lack of scalability. Arbitrage or relative value trading is less likely to close the mispricing.

How using OSAM data, he tried to gain insight into how factors work

• Value and momentum work very differently
• His “Factors From Scratch” work with OSAM (O’Shaugnessey Asset Management)
• My own notes on his post as well as the related OSAM work on “Alpha Within Factors”