Shorting has made it back into the headlines because a number of directors and financial commentators are seeking to blame it for the fall of civilization, or at the very least the fact that bank shares have taken a beating.

From a personal perspective, I write at the end of a breathless week’s trading – one in which I traded more successfully than ever before, all on the short side. I’ve written before about how I try to stay calm and not get excited about winning or losing but, at the moment, I can’t help smiling a lot!

The fun couldn’t last though. I wrote just over a year ago about how powerful forces will do whatever they can to skew the market to favor long positions. And so it has come to pass that restrictions have been introduced on short selling, first in the UK and then the US.

I can sympathize with the need for restrictions to some extent. If banks such as HBOS in the UK were allowed to go bust, the lost deposits and the need for tax-payers to refund people’s savings would drive economies into depression. There was also the suspicion that traders on the short side were spreading rumors to undermine the stocks they were shorting.

Financial commentators need to get things in perspective though. Short selling hasn’t destroyed the banks’ balance sheets and reputations. Bad management alone has done that. Short selling can merely accelerate the discovery process and bring to light the fundamentally poor risk management practiced by people who – given their enormous remuneration levels – should have known better.

It looks, though, that shorting didn’t actually have much to do with the situation. Take HBOS again. During the three-day price slump culminating in its takeover, 990 million HBOS shares were traded – that’s almost 19 percent of the stock. Yet figures from dataexplorers.com show only 3 percent of HBOS stock was on loan. (Fannie Mae and Freddie Mac at some stages peaked at 40 percent loaned.) So for UK authorities to blame shorting for HBOS’s predicament and then use this as the basis for trading restrictions seems a bit like blaming a mouse because a dog ate your supper.

I enjoyed the quote at the end of the week from SEC chairman Christopher Cox:

“The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.”

In a rational world, we would of course apply the same high-minded approach during bull markets, when stocks are talked up rather than down and companies are able to fund takeovers of other companies using the value of their own hyped stock as capital. We don’t though. We allow these bull-market frauds to continue. They only seem to be exposed finally by falling stock prices. (These evil short sellers again!) Still, I shouldn’t complain too much; bull markets that continue for too long are easy to profit from, because you can simply sit on the trend for as long as it runs.

The week’s happy/sad events bring Jesse Livermore’s short-selling career to mind. Here’s what he had to say in Reminiscences of a Stock Operator about how he and others brought the market to its knees through short selling, and why he stopped selling and went long before he caused a country wide (not Countrywide!) catastrophe:

Things got worse and worse. Finally there came the awful day of reckoning for the bulls and the optimists and the wishful thinkers and those vast hordes that, dreading the pain of a small loss at the beginning, were now about to suffer total amputation without anaesthetics.

My friend’s partner was as bearish as I was. The firm therefore did not have to borrow, but my friend, the broker I told you about, fresh from seeing the haggard faces around the Money Post, came to me. He knew I was heavily short of the entire market.

I had seen a smash coming, but not, I admit, the worst panic in our history. It might not be profitable to anybody if it went much further. Finally it became plain that there was no use in waiting at the Post for money. There wasn’t going to be any. Then hell broke loose.
The president of the Stock Exchange, Mr. R. H. Thomas, so I heard later in the day, knowing that every house in the Street was headed for disaster, went out in search of succor. He called on James Stillman, president of the National City Bank, the richest bank in the United States. Its boast was that it never loaned money at a higher rate than 6
per cent. Stillman heard what the president of the New York Stock Exchange had to say. Then he said, “Mr. Thomas, we’ll have to go and see Mr. Morgan about this.”

The two men, hoping to stave off the most disastrous panic in our financial history, went together to the office of J. P. Morgan & Co. and saw Mr. Morgan. Mr. Thomas laid the case before him. The moment he got through speaking Mr. Morgan said, “Go back to the Exchange and tell them that there will be money for them.”

“Where?”

“At the banks!”

So strong was the faith of all men in Mr. Morgan in those critical times that Thomas didn’t wait for further details but rushed back to the floor of the Exchange to announce the reprieve to his death-sentenced fellow members.

Then, before half past two in the afternoon, J. P. Morgan sent John T. Atterbury, of Van Emburgh & Atterbury, who was known to have close relations with J. P. Morgan & Co., into the money crowd. My friend said that the old broker walked quickly to the Money Post. He raised his hand like an exhorter at a revival meeting. The crowd, that at first had been calmed down somewhat by President Thomas’ announcement, was beginning to fear that the relief plans had miscarried and the worst was still to come.

I heard a day or two later that Mr. Morgan simply sent word to the frightened bankers of New York that they must provide the money the Stock Exchange needed.

“But we haven’t got any. We’re loaned up to the hilt,” the banks protested.
“You’ve got your reserves,” snapped J. P. “But we’re already below the legal limit,” they howled

“Use them! That’s what reserves are for!” And the banks obeyed and invaded the reserves to the extent of about twenty million dollars. It saved the stock market. The bank panic didn’t come until the following week. He was a man, J. P. Morgan was. They don’t come much bigger.

That was the day I remember most vividly of all the days of my life as a stock operator.

That morning a broker who had done a lot of business for my brokers and knew that I had been plunging on the bear side rode down in the company of one of the partners of the foremost banking house in the Street. My friend told the banker how heavily I had been trading, for I certainly pushed my luck to the limit. What is the use of being right unless you get all the good possible out of it?

Perhaps the broker exaggerated to make his story sound important. Perhaps I had more of a following than I knew. Perhaps the banker knew far better than I how critical the situation was. At all events, my friend said to me: “He listened with great interest to what I told him you said the market was going to do when the real selling began, after another push or two. When I got through he said he might have something for me to do later in the day.

“When the commission houses found out there was not a cent to be had at any price I knew the time had come. I sent brokers into the various crowds. Why, at one time there wasn’t a single bid for Union Pacific. Not at any price! Think of it! And in other stocks the same thing. No money to hold stocks and nobody to buy them.

I had enormous paper profits and the certainty that all that I had to do to smash prices still more was to send in orders to sell ten thousand shares each of Union Pacific and of a half dozen other good dividend-paying stocks and what would follow would be simply hell. It seemed to me that the panic that would be precipitated would be of such an intensity and character that the board of governors would deem it advisable to close the Exchange, as was done in August, 1914, when the World War broke out.

It would mean greatly increased profits on paper. It might also mean an inability to convert those profits into actual cash. But there were other things to consider, and one was that a further break would retard the recovery that I was beginning to figure on, the compensating improvement after all that bloodletting. Such a panic would do much harm to the country generally.

I made up my mind that since it was unwise and unpleasant to continue actively bearish it was illogical for me to stay short. So I turned and began to buy. It wasn’t long after my brokers began to buy in for me and, by the way, I got bottom prices that the banker sent for my friend.

“I have sent for you,” he said, “because I want you to go instantly to your friend Livingston and say to him that we hope he will not sell any more stocks to-day. The market can’t stand much more pressure. As it is, it will be an immensely difficult task to avert a devastating panic. Appeal to your friend’s patriotism. This is a case where a man has to work for the benefit of all. Let me know at once what he says.”

My friend came right over and told me. He was very tactful. I suppose he thought that having planned to smash the market I would consider his request as equivalent to throwing away the chance to make about ten million dollars. He knew I was sore on some of the big guns for the way they had acted trying to land the public with a lot of stock when they knew as well as I did what was coming.

As a matter of fact, the big men were big sufferers and lots of the stocks I bought at the very bottom were in famous financial names. I didn’t know it at the time, but it did not matter. I had practically covered all my shorts and it seemed to me there was a chance to buy stocks cheap and help the needed recovery in prices at the same time if nobody hammered the market.

So I told my friend, “Go back and tell Mr. Blank that I agree with them and that I fully realized the gravity of the situation even before he sent for you. I not only will not sell any more stocks to-day, but I am going in and buy as much as I can carry.” And I kept my word. I bought one hundred thousand shares that day, for the long account. I did not sell another stock short for nine months.

That is why I said to friends that my dream had come true and that I had been king for a moment. The stock market at one time that day certainly was at the mercy of anybody who wanted to hammer it. I do not surfer from delusions of grandeur; in fact you know how I feel about being accused of raiding the market and about the way my operations are exaggerated by the gossip of the Street. I came out of it in fine shape. The newspapers said that Larry Livingston, the Boy Plunger, had made several millions. Well, I was worth over one million after the close of business that day. But my biggest winnings were not in dollars but in the intangibles: I had been right, I had looked ahead and followed a clear-cut plan. I had learned what a man must do in order to make big money; I was permanently out of the gambler class; I had at last learned to trade intelligently in a big way. It was a day of days for me.

Jesse Livermore learned about the best stock tips the hard way.

Having learned his lesson, he enjoyed discussing how their willingness to take stock tips had hit other traders in their pockets.

In this excerpt from Reminiscences of a Stock Operator, ‘Larry Livingston’ (aka Jesse Livermore) tells the tale of Walker, Hood and the Atlantic & Southern tips:

But the prize tip story of my collection concerns one of the most popular members of the New York Stock Exchange, J. T. Hood. One day another floor trader, Bert Walker, told him that he had done a good turn to a prominent director of the Atlantic & Southern. In return the grateful insider told him to buy all the A. & S. he could carry.

The directors were going to do something that would put the stock up at least twenty-five points. All the directors were not in the deal, but the majority would be sure to vote as wanted.

Bert Walker concluded that the dividend rate was going to be raised. He told his friend Hood and they each bought a couple of thousand shares of A. & S. The stock was very weak, before and after they bought, but Hood said that was obviously intended to facilitate accumulation by the inside clique, headed by Bert’s grateful friend.

On the following Thursday, after the market closed, the directors of the Atlantic & Southern met and passed the dividend. The stock broke six points in the first six minutes of trading Friday morning.

Bert Walker was sore as a pup. He called on the grateful director, who was broken-hearted about it and very penitent. He said that he had forgotten that he had told Walker to buy. That was the reason he had neglected to call him up to tell him of a change in the plans of the dominant faction in the board. The remorseful director was so anxious to make up that he gave Bert another tip. He kindly explained that a couple of his colleagues wanted to get cheap stock and against his judgment resorted to coarse work.

He had to yield to win their votes. But now that they all had accumulated their full lines there was nothing to stop the advance. It was a double, riveted, lead-pipe cinch to buy A. & S. now.

Bert not only forgave him but shook hands warmly with the high financier. Naturally he hastened to find his friend and fellow-victim, Hood, to impart the glad tidings to him.

They were going to make a killing. The stock had been tipped for a rise before and they bought. But now it was fifteen points lower. That made it a cinch. So they bought five thousand shares, joint account.

As if they had rung a bell to start it, the stock broke badly on what quite obviously was inside selling. Two specialists cheerfully confirmed the suspicion. Hood sold out their five thousand shares. When he got through Bert Walker said to him, “If that blankety blank blanker hadn’t gone to Florida day before yesterday I’d lick the stuffing out of him.

Yes, I would. But you come with me.”

“Where to?” asked Hood.

“To the telegraph office. I want to send that skunk a telegram that he’ll never forget. Come on.”

Hood went on. Bert led the way to the telegraph office. There, carried away by his feelings they had taken quite a loss on the five thousand shares he composed a masterpiece of vituperation. He read it to Hood and finished, “That will come pretty near to showing him what I think of him.”

He was about to slide it toward the waiting clerk when Hood said, “Hold on, Bert!”

“What’s the matter?”

“I wouldn’t send it,” advised Hood earnestly.

“Why not?” snapped Bert.

“It will make him sore as the dickens.”

“That’s what we want, isn’t it?” said Bert, looking at Hood in surprise. But Hood shook his head disapprovingly and said in all seriousness,

“We’ll never get another tip from him if you send that telegram!”

A professional trader actually said that. Now what’s the use of talking about sucker tip-takers?

In How to Trade in Stocks, Jesse Livermore wrote:

I have warned against averaging losses. That is a most common practice. Great numbers of people will buy a stock, let us say at 50, and two or three days later if they can buy it at 47 they are seized with the urge to average down by buying another hundred shares, making a price of 48.5 on all.

Having bought at 50 and being concerned over a three-point loss on a hundred shares, what rhyme or reason is there in adding another hundred shares and having the worry double when the price hits 44? At that point there would be a $600 loss on the first hundred shares and a $300 loss on the second hundred shares.

If one is to apply such an unsound principle, he should keep on averaging by buying two hundred shares at 44, then four hundred at 41, eight hundred at 38, sixteen hundred at 35, thirty-two hundred at 32, sixty-four hundred at 29 and so on.

How many speculators could stand such pressure?

So, at the risk of repetition and preaching, let me urge you to avoid averaging down… Why send good money after bad? Keep that good money for another day. Risk it on something more attractive than an obviously losing deal.

Pyramiding

In practice, Jesse Livermore would have traded with the trend, against the “suckers” averaging down. Since the stock price was falling, he would have sold it short and, as the price continued to fall, he would have pyramided his position. Every time the market moved in his favor, he would have bought a larger number of shares than he had bought the previous time. His gains would be identical to the losses incurred by someone who was averaging down.

People sometimes make the mistake of believing that Jesse Livermore was a purely technical trader.

It’s true that Jesse would try to exploit the market using his technically based tape-reading skills and it’s also true he wouldn’t worry too much about the reasons behind the numbers on the tape.

At other times though – as he explained in Reminiscences of a Stock Operator - he would act on his understanding of the fundamental economics of a situation.

The United State World Trade Corporation operated around the world. It owned shipping lines, coffee plantations in Guatemala, hydroelectric plants in Bolivia, banks in Peru and conducted a huge export business. In a bear market, the public remembered that USWT’s business was spread all over the world and so could divide its risks. The company continued to pay its quarterly dividend.

The bear market developed with severe declines. USWT stock descended in a leisurely manner. One day when the rest of the market showed an improvement, USWT stock suddenly fell five points on the highest volume in months.

USWT’s president and directors assured the public and the press that nothing was wrong and denied rumors that the dividend would be cut.

Instead of rallying, however, the stock fell further the next day and continued falling.

Then, to a chorus of outrage, the directors announced that there would be no quarterly dividend.

Why did USWT suddenly fall?

Jesse Livermore had been analyzing the export trade and conditions in South America and the Far East and had concluded that the economic conditions were not favorable and were going to worsen.

He looked for the stock that would corroborate and justify his opinion of basic conditions. There was USWT, whose price was falling, but had not been as badly sold down as many other stocks.

He got USWT’s annual reports for three years and then, when he understood the company’s finances as well as the underlying conditions in every one of the company’s lines of business, he sold short ten thousand shares of the stock.

He began at 110. The next morning, he read the president’s statement:

“I’ll tell you that there has been no talk whatever about it, and no desire or intention of either reducing or passing the next dividend. I hope we may never have to do that.”

This had the effect of making Livermore sell another ten thousand shares short, and the price broke so badly that he was encouraged to put out an additional short line of ten thousand shares on the third day.

Now the share price had fallen to the 80s. There was no inside support to speak of, and the room-traders on the floor saw it and sold so recklessly that the stock had a good rally on their covering.

Then came the last grand drive, at the opening, on the day after the directors’ meeting. Livermore took advantage of the big collapse to cover his shorts at a little above 60. He commented:

“I made a killing on that stock. I didn’t need any inside tip.”

Edwin Lefevre said to Livermore:

“And the beauty of it is that Wall Street accused the directors of speculating in their own shares. Do you remember the shriek the newspapers let out when the stock broke after the president came out with a statement that they were not going to pass the dividend? They did not know it was your selling. I happen to know that the decision to pass the dividend was not reached by the directors until two minutes before they took a vote on it.”

“Well,” said Livermore, “I reached it for them two weeks before they voted… I knew they must [pass the dividend]. I knew they must; if not this time, three months later.”

George Taylor emailed me asking why I don’t share the complete details of my personal trading methods. While I’m more than happy to talk about the general principles of how to trade and how Jesse Livermore’s view of trading can still be used as the basis of a trading system today, I won’t share specific details of my own techniques. Here’s why:

If you have a trading system that gives you an edge, you don’t go sharing it - not if you want to keep using it profitably. Think of it this way:

Imagine you discovered that at 4 a.m. each morning 100 gold coins would magically appear, scattered over a local beach. Getting up in the middle of the night is a pain but for 100 gold coins – well it’s good money. After a few days, in a generous mood, you share your secret with your best friend. Next morning at 4 a.m., you’ve got company on the beach. Your friend is there too – following an identical strategy to yours, gathering up the coins. From now on, you’re averaging only 50 coins a night.

Things go from bad to worse. Your friend tells his brother and his brother tells his uncle about the coins. Now you’re averaging 25 coins a night. Before too long, over 100 people know about the beach and then thousands have learned the secret. People are now making more money from selling books about gold coins on the beach than they are from actually going to the beach.

Arriving on the beach at 4 a.m. is no longer a useful strategy. It costs you more getting to the beach than you’ll be able to take in profit.

I hope that helps.

As its price rises to fresh heights I’m going to return to the topic of oil.

At the beginning of July 2007 I wrote about how I had profited from my long-term view of oil prices and I mentioned three stocks I got into several years ago. As of July 2007, the Canadian Oil Sands Trust (COS-UN.TO) had quadrupled in price in five years, Suncor (SU) had quintupled and UTS Energy (UTS.TO) had sextupled.

So, since then, what has happened to the prices of these stocks?

COS-UN.TO from 32.94 to 48.18 …………..up 46.3%

UTS.TO from 6.06 to 5.45 …………..down 10.0%

SU from 89.92 to 120.44 …………..up 33.9%

In ten months the average rise has been 23.4% (equal weighting) giving an annualized return of 27.5% - which is pretty good.

It would have been a lot better if I’d ditched UTS.TO last year, when it looked like the long-term uptrend was over. I was very patient with UTS.TO though because of my bullish view of oil in general, but it’s time to call it a day. I have now culled UTS.TO because its chart has been moribund for a couple of years. I’ll keep my eye on the other two stocks because the long-term slope of the uptrend has reduced in the last couple of years and it may be time to reassess how I should try to profit from oil in the long term.

I say this especially because I got into these stocks because I thought their price would rise faster than the price of oil. In the past year, however, the price of oil has doubled and the stocks haven’t kept pace.

Today’s Oil News

Goldman Sachs has predicted that oil could rise to $150 to $200 within two years as a result of demand rising faster than supply. (Others disagree.)

Why I Agree with Goldman Sachs and why Hillary Clinton won’t increase anyone’s Oil Production

I tend to avoid politics but I noted Hillary Clinton saying yesterday that she was going to use anti-trust legislation to force the OPEC cartel to pump more oil and bring the price down. Okay, yes, it’s a “political promise” - most of which are worthless - but I’ll use it to make my own point.

My question for Hillary Clinton is: why not use anti-trust legislation to force Texas to quadruple its oil output? Surely that would be easier to enact? The trouble is, of course, that Texas is running out of oil and governments can’t legislate for the magical creation of new oil. (Although the Fed seems to be doing it all the time with money!)

Just as Texas produces less oil than it used to, so does Saudi Arabia, the world’s biggest producer. Saudi Arabian oil production has almost certainly passed its peak. Hillary, you can’t force a country to pump oil it doesn’t have using anti-trust legislation.

Once we are aware of the initial velocity of an object we can accurately predict its entire journey. We use these principles to send spaceships to other planets. Similarly with oil, once we have the first few years’ of production data from a single oil field, or from a country’s oil fields or indeed a planet’s oil fields we can predict the entire trajectory of oil production. This is the basis of the famous Hubbert Curve and Peak. (Google it if you’re one of the few not yet familiar with it.)

This is the heart of the problem. The world’s population continues to rise. Industrialisation of the huge population centers of China and India continues apace. And – just like Texas produces less oil than it used to - so will planet Earth. It may be we’ve reached the peak. It may be the peak is still a year or two away.

Where will the price of oil go? In the short term, I don’t know. As traders we know that when a price trends upward, more people buy for technical reasons – trend followers, momentum traders, chartists - technical analysts of all persuasions. It’s difficult to say how much of today’s price is driven by speculation.

I’m happy to trade on the long-term trend without worrying massively about the fundamentals.

When I consider the fundamentals, the only thing I see that can bring the long-term price of oil down is reduced demand relative to supply; but I don’t see many signs of this happening.