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Downfall of the Cotton King

Every year there are hundreds of new books released about investing or trading stocks. But only a precious few become enduring classics.

True knowledge is timeless. Published nearly 90 years ago, Reminiscences of a Stock Operator, by Edwin Lefevre, has stood the test of time and qualifies as a must-read for all who are interested in the stock market. I admit a personal affinity for Lefevre’s work; it was one of the first investing books I read and helped instill in me a lifelong passion for the financial markets.

Reminiscences recounts the experiences of a fictional trader named Larry Livingstone but is really a thinly-veiled biography of Jesse Lauriston Livermore, a legendary trader from the early 20th century. While Reminiscences was first published in 1923, Livermore is probably best known for making millions in the stock market crash of 1929--and back then being a millionaire meant a good deal more than it does today.

Livermore was also famous for going broke; he made and lost several fortunes during his career, though he always made good on his debts. Some of the most interesting passages in Reminiscences are those concerning Livermore’s mistakes. It’s truly amazing to watch modern investors lose money making the very same errors Livermore made almost a century earlier. Human nature never changes.

One of Livermore’s most costly trading mistakes involved a man named Percy Thomas, who was known as the “Cotton King” to his contemporaries. Thomas had a reputation as a well-informed and successful speculator in the cotton markets and attracted a considerable following in both the US and Europe.

Livermore befriended Thomas and, inevitably, their conversations turned to cotton. At the time Livermore was short cotton (betting on a fall), while Percy Thomas was a cotton bull. Livermore admits that when he started talking to Thomas he couldn’t see the bull case for cotton at all, but Thomas brought up so many facts and figures in support of his opinion that Livermore ultimately relented, becoming convinced he was wrong and Thomas was right.

As Livermore  states in Reminiscences: “A man cannot be convinced against his own convictions, but he can be talked into a state of uncertainty and indecision, which is even worse , for it means that he cannot trade with confidence and comfort.”

Livermore not only covered his shorts and bought cotton. But he continued to buy cotton even as the trade soured, and he began to lose money. In what Livermore calls the most asinine move of his career, he actually took profits in wheat and other markets to maintain his money-losing cotton position. Ultimately, Livermore was nearly ruined by that single trade.

Livermore was talked out of his convictions in cotton because of information presented to him by a man he describes as brilliant and a “magnetic” personality. The lengthy series of facts and inside information that Thomas presented to Livermore cost him dearly.

Although it isn’t explicitly written in Reminiscences, Thomas likely wasn’t intentionally misleading Livermore. It’s likely he truly believed in the strength of his analysis and the quality of his contacts in the cotton-growing region of the Southern US. Thomas was falling prey to a classic mistake: fighting the tape by ignoring market action and the fundamental bearish news surrounding cotton markets.

Human beings have an almost limitless capacity to look at a large amount of data and find some patterns to support their pre-conceived notions. I have no doubt Percy Thomas was predisposed to be bullish cotton and found plenty of information he could use to back up his view.

Just as Livermore was blinded by Thomas’ eloquent analysis and talked into a state of uncertainty, it’s all too easy for modern investors to be led astray by the seemingly endless data releases and market commentary available these days. The information overload leads to paralysis as investors stubbornly cling to a particular view even when a dispassionate read of the market and fundamental data points in another direction.

It’s human nature to identify oneself as a market “bull” or a “bear,” and these classifications are perennially reinforced in the popular media. However, as Livermore once said, “[T]here’s no bull side and no bear side, only the right side.” Just as it was hard for Percy Thomas to shed his Cotton bull predilections it’s hard for most investors to divorce themselves of long-held beliefs when conditions change.

In some professions perseverance and downright stubbornness are positive attributes. But that’s not the case with investing. Flexibility and a willingness to alter your view are absolutely necessary.

The Bear’s Den

Following conversations with scores of investors at the Orlando MoneyShow earlier this month, it became clear that most are at heart negative on the US stock market and economy. Since the 2009 Orlando conference, global equity markets have enjoyed one of the most powerful rallies in history, but that move has done little to dispel bearish sentiment.

As longtime readers know, I have considerable sympathy for this view. Over the past six months I’ve discussed at length the longer-term headwinds the US and many other developed countries face in coming years.

Some investors asked if my near-term bullish stance reflected a belief that the stimulus package passed roughly a year ago is working. The answer to that question is an emphatic no. Although I’m certainly aware that if you throw enough money at something it will probably go up in price, I firmly believe the longer-term damage caused by excessive government spending far outweighs any near-term benefit.

I continue to believe that the experience of the United Kingdom in the 1960’s and ’70s remains relevant to the US today.

But we can’t make money by doggedly and stubbornly sticking to the bearish case when market realities and the data point in another direction. It’s certainly possible to sift through the dozens of economic releases released in the US and overseas each week to find some data to suggest the economy is destined for a double dip this year and that the market is ready to make a major move to the downside.

Jesse Livermore lost most of his fortune by ignoring his own convictions and the market to listen to the Cotton King. And Percy Thomas convinced himself he was right to be bullish by seeking out data to support that view. Both men were nearly ruined by the experience.

Emotions have no place in the market, and to make money it’s important to analyze the market and economy dispassionately. One of the best ways I know to control emotions is to   identify a toolbox of data points and indicators that you follow consistently; if your market positioning isn’t in line with those indicators you should seriously re-examine your rationale; you may well be making the same mistake Thomas and Livermore did nearly a century ago.

The Conference Board’s Leading Economic Index (LEI) is one indicator I follow closely.

Paying attention to the signals the LEI gives helped me to call for a recession in January 2008 in The Energy Strategist, when many pundits were still predicting the US would skirt recession. The LEI also told me that conditions were beginning to improve last spring and convinced me it was time to more aggressively play the bull side.

I’ve analyzed the patterns in this indicator over several decades, and it’s not perfect. But the LEI offers good, consistent signals and shouldn’t be ignored.

Source: Bloomberg

This chart shows data on two indexes, the LEI and US year-over-year change in gross domestic product (NYSEMKT:GDP). The LEI is released monthly, but I used quarterly data to make it comparable to GDP. Please note that the current year-over-year change in GDP is around 0.1 percent; the more commonly quoted 5.7 percent figure for the fourth quarter is  simply the fourth-quarter growth rate on an annualized basis. I’ve presented data back to the mid ’60s.

Although the correlation isn’t exact, it’s clear that turns in the LEI have typically done a good job of calling turns in economic growth a few months into the future. It’s not hard to see that the purple line on my chart (the LEI) has a tendency to bottom a quarter or two before economic growth also hits a nadir.

Similarly, note how sharp declines in the LEI data often presage a significant slowdown in GDP a few quarters in advance.

Plenty of pundits would argue that the LEI isn’t relevant in this cycle because this one is different than past experiences. I agree that there are differences with this cycle, but it’s tough to dispassionately look at a chart like this without recognizing the relevance of the LEI as an indicator.

And the indicator seemed to work equally well during the high-unemployment environment of the ’70s; “this time is different” is the most expensive phrase in finance, and I wouldn’t be so quick to ignore the LEI. My basic premise is that the secular trend for the US economy has taken a turn for the worse, but this doesn’t mean the business cycle is irrelevant. The LEI signals a continuing cyclical recovery for the US in 2010, not a double-dip recession.

Note that the latest LEI data, released for January, isn’t pictured on this chart because I’m using quarterly data. But the LEI jumped another 0.3 percent for the month, slightly below the consensus forecast. However, the Conference Board also revised upward the prior month’s data. All told, the latest reading on LEI continues to point to recovery.

And for those who still consider the LEI to be imperfect, the Conference Board also releases two additional indicators as part of the same monthly release, the Coincident Economic Index (NYSEMKT:CEI) and the Lagging Economic Index (LAG). The CEI is designed to reflect changes in economic conditions as they happen, while the LAG tends to act as a confirming indicator, making turns months after the broader economy.

Here’s a chart of CEI and GDP depicted on the same basis as LEI and GDP above.

Source: Bloomberg

This chart is actually a bit harder to read than the LEI-GDP chart because the lines often so closely overlap. It’s fair to say that the CEI and GDP tend to follow very similar patterns. As you can see, the CEI began has begun to turn again this cycle at exactly the same time GDP bottomed out.

The CEI was up another 0.2 percent in January, with three out of the four constituent indicators advancing. Out of the past seven months the CEI has increased in four months and has remained flat in the remaining three. Like the LEI, the CEI points to a recovery.

Many investors argue with LEI signals because several of the constituent indicators-- including money supply and interest-rate spreads--are heavily influenced by the government.

The CEI at least partly addressed this concern; it has only four constituent indicators, and none are as directly under the government’s control. Here are the indicators in the CEI, in order of importance: employees on nonagricultural payrolls; personal income less transfer payments; industrial production and manufacturing; and trade sales. Note that even the personal income indicator nets out government transfer payments.

The LEI and the CEI tell me that, long-term structural concerns aside, the US economy is enjoying a cyclical recovery. And that spells more upside for stocks this year.

Stocks on the Run

I’ve been speaking at investment conferences and for smaller investment groups for more than seven years. By far the most common question I’m asked is “What’s your top stock pick right now?”

Investors always want to come away from each workshop with at least one or two high-quality investment ideas; for me the problem has always been narrowing down my favorites to just one or two names.

Every week, I have a working lunch with my colleague Yiannis Mostrous, editor of The Silk Road Investor. As you might imagine, the conversation inevitably turns to the market and our favorite stocks and investment ideas. These lunches have evolved into a sort of friendly competition over who comes up with the best ideas; the competition and need to defend my views has certainly inspired me to flush out some profitable investment ideas over time.

Last October I was at Yiannis’ home for a late-season barbeque. Over a glass of wine and the remnants of a rib eye we came up with a simple concept: Why not offer the ideas we come up with in our weekly meetings to our broader subscriber base?

Even better, why not address investors’ desire for a straightforward, clear investment idea--a top stock pick--each month by leveraging the fruits of our conversations and debates?

That’s the idea behind our brand new advisory, Stocks on the Run. Each issue, on the first Monday of the month, contains a single stock recommendation vetted by both of us along with the basic rationale for buying. The service is designed to be simple and straightforward -- no lengthy economic analysis, no extraneous commentary about the broader market, just a simple, profitable stock to buy now.

The service won’t leave you hanging. Each monthly e-mail will contain advice on what to do with prior recommendations, and we’ll send out alerts as needed to update recommendations between issues.

Our February pick--a play on agriculture--is already on the move, and we’ve identified a short list of candidates for the March play. We’re meeting next week to make the final decision on our next pick.

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Race to the Summit

A panel discussion on the state of the economy. Presentations by each of our expert editors. One-on-one time with those experts. A sunset cruise of San Diego Bay…

April 23-24 could be your most important weekend of the year. Roger Conrad, GS Early, Yiannis Mostrous, Benjamin Shepherd and I will reveal the brightest trends and our best recommendations--and anything else you might want to know--during the 2010 Wealth Society Member Summit at the historic Hotel del Coronado.

They say it’s 72 and sunny every day of the year in San Diego, and in late April it probably will be. Tranquility and relaxation is good; that and the best independent view of global investing make a great combination. You may find all details at

Call 1-800-832-2330 (between 9:00 a.m. and 5:00 p.m. EST Monday through Friday) or go online now to reserve your seat at the table. Space is limited.

Elliott Gue is Editor of Personal Finance, The Energy Strategist, and Co-Editor of MLP Profits.

Disclosure: "No Positions"