The Rules of Trading

John Mauldin | Thoughts from the Frontline
January 20, 2006

The economy created 215,000 new jobs in November. A paltry 11,000 were manufacturing. Is that good enough? In previous recoveries we would have been seeing jobs created at a much higher level. But that number is not quite the story. Actually, we saw 4,586,000 new hires in November. That is not a typo. The reality of employment in the US is quite a bit different than the employment numbers often suggest. We look at a relatively new database that sheds some very interesting light on how amazingly dynamic the job market in the US is.

I write this week's letter as I fly from Toronto to Miami. It will be a little shorter than a regular letter, but I also include a chapter from Just One Thing. It is Dennis Gartman's Rules of Trading. I saw Dennis briefly last night, as we were both speaking at an RBC (Royal Bank of Canada) conference, and was reminded after a few of his great stories of just what a really smart trader he is. For those new to this letter, Just One Thing is my latest book which features the writing of 11 of my friends and your humble analyst writing about the one thing we find most important that we have learned in our careers. You won't find stock tips or the latest how-to-turn a thousand into a million in five easy lessons, but you will get solid philosophical grounding on the basic principles of economics and investing from a group of really smart, successful guys (and then my musings as well). You can get your copy at your local bookstore or go to Amazon at www.amazon.com/justonething.

JOLTS

The Bureau of Labor Statistics of the U.S. Department of Labor conducts a monthly survey called Job Openings and Labor Turnover Survey (JOLTS). The program involves the collection and publishing of job openings and labor turnover data. The data, collected from sampled establishments on a voluntary basis, include employment, job openings, hires, quits, layoffs and discharges, and other separations.

The number of unfilled jobs--used to calculate the job openings rate--is an important measure of the unmet demand for labor. With that statistic, it is possible to paint a more complete picture of the U.S. labor market than by looking solely at the unemployment rate, a measure of the excess supply of labor.

I ran across this database recently, and must admit I was fascinated, but then again, I am easily amused. They only began collecting this data in December of 2002, so we have very little basis on which to make historical comparisons, but what we do have is still eye-opening. Let's look at some of the data points. You can go to the source yourself at http://www.stats.bls.gov/news.release/pdf/jolts.pdf.

First, on the last business day of November 2005 (the most recent data), there were 3.9 million job openings in the United States, and the job openings rate was 2.8%. The job openings rate did not change significantly in November, but has generally trended upward since September 2003 from below 2%. The job openings rate is the number of job openings on the last business day of the month as a percent of total employment plus job openings. So, by this measure, the job market is 40% better than it was two years ago. Of course, we do not known how good the market was in 1999, so this may be misleading. But the recent trend is a good thing.

As noted above, 4,586,000 people found a new job in November. But 4,337,000 needed to find new jobs, as they left their old jobs for one reason or another.

Let's data mine a little for some interesting items. There were 349,000 manufacturing job openings. Sounds like a lot, but there were 516,000 jobs available at leisure and hospitality firms. There were 713,000 job openings for professional and business service firms. Education and health (not sure why they are lumped together) offers 594,000 opportunities. It is easier to find a job in the South, and even easier in the West.

2,612,000 people said "take this job and shove it" or at least left for presumably greener pastures. 1,498,000 people heard Donald Trump's famous line, "you're fired" or were simply laid off. Between quits and layoffs, roughly 1.1% of the country lost a job they presumably wanted to keep in just one month! That easily translates into over 10% of American employees in any one year losing a job.

249,000 more people were hired than fired when you cross those numbers, but an amazing (to me) 3.4% of the country found new jobs in just one month! That means almost 40% of employees this year will change jobs. Now, this is not getting promoted to a better position or moving from one position in a company to another, but changing the actual firm for which you work.

Of course, a lot of the job fluidity can be explained by younger people changing jobs, temporary seasonal help and so on. I have six kids now in the work force, with five in school either full-time or part time. Between them they worked for 11 different employers last year. Only two had the same employer at the end of the year as at the beginning, and one of them works for me and she is not allowed to leave under any circumstances as my business would collapse, or at least I would.

On the margin, we need to create a net new 150,000 jobs a month or so to keep the unemployment rate from rising, due to growth of population, etc. But that aside, the data points to a remarkably dynamic and fluid job market in the US. It also means that we are creating a lot more than 150,000 jobs a month. More like a few million, but we are losing a few hundred thousand less than that few million. For a lot of America, employment is not a certain prospect.

This suggests one of the reasons we know that the consumer sentiment numbers are closely related to how one feels about keeping his job. When things get dicey at work, employees can sense it and get nervous.

Is this an investable idea? No, but it is something to be aware of when we look at the state of the economy.

Now, let's turn to Dennis Gartman's Rules of Trading.

The "Not-So-Simple" (But Really Utterly So) Rules of Trading

The world of investing/treading, even at the very highest levels, where we are supposed to believe that wisdom prevails and profits abound, is littered with the wreckage of wealth that has hit the various myriad rocks that exist just beneath the tranquil surface of the global economy. It matters not what level of supposed wisdom, or education, that the money managers or individuals in question have. We can make a list of wondrously large financial failures that have come to flounder upon these rocks for the very same reasons. Let us, for a bit, have a moment of collective silence for Long Term Capital Management; for Baring's Brothers; for Sumitomo Copper... and for the tens of thousands of individuals each year who follow their lead into financial oblivion.

I've been in the business of trading since the early 1970s as a bank trader, as a member of the Chicago Board of Trade, as a private investor, and as the writer of The Gartman Letter , a daily newsletter I've been producing for primarily institutional clientele since the middle 1980s. I've survived, but often just barely. I've made preposterous errors of judgment. I've made wondrously insightful "plays." I've understood, from time to time, basis economic fundamentals that should drive prices--and then don't. I've misunderstood other economic fundamentals that, in retrospect, were 180 degrees out of logic and yet prevailed profitably. I've prospered; I've almost failed utterly. I've won, I've lost, and I've broken even.

As I get older, and in my mid-50s, having seen so much of the game--for a game it is, with bad players who get lucky; great players who get unlucky; mediocre players who find their slot in the lineup and produce nice, steady results over long periods of time; "streak-y" players who score big for a while and lose big at other times--I have distilled what it is that we do to survive into a series of "Not-So-Simple" Rules of Trading that I try my best to live by every day ... every week ... every month. When I do stand by my rules, I prosper; when I don't, I don't. I am convinced that had Long Term Capital Management not listened to its myriad Nobel Laureates in Economics and had instead followed these rules, it would not only still be extant, it would be enormously larger, preposterously profitable and an example to everyone. I am convinced that had Nick Leeson and Barings Brothers adhered to these rules, Barings too would be alive and functioning. Perhaps the same might even be said for Mr. Hamanaka and Sumitomo Copper.

Now, onto the Rules:

NEVER ADD TO A LOSING POSITION

R U L E # 1
Never, ever, under any circumstance, should one add to a losing position ... not EVER!

Averaging down into a losing trade is the only thing that will assuredly take you out of the investment business. This is what took LTCM out. This is what took Barings Brothers out; this is what took Sumitomo Copper out, and this is what takes most losing investors out. The only thing that can happen to you when you average down into a long position (or up into a short position) is that your net worth must decline. Oh, it may turn around eventually and your decision to average down may be proven fortuitous, but for every example of fortune shining we can give an example of fortune turning bleak and deadly.

By contrast, if you buy a stock or a commodity or a currency at progressively higher prices, the only thing that can happen to your net worth is that it shall rise. Eventually, all prices tumble. Eventually, the last position you buy, at progressively higher prices, shall prove to be a loser, and it is at that point that you will have to exit your position. However, as long as you buy at higher prices, the market is telling you that you are correct in your analysis and you should continue to trade accordingly.

R U L E # 2
Never, ever, under any circumstance, should one add to a losing position ... not EVER!

We trust our point is made. If "location, location, location" are the first three rules of investing in real estate, then the first two rules of trading equities, debt, commodities, currencies, and so on are these: never add to a losing position.

INVEST ON THE SIDE THAT IS WINNING

R U L E # 3
Learn to trade like a mercenary guerrilla.

The great Jesse Livermore once said that it is not our duty to trade upon the bullish side, nor the bearish side, but upon the winning side. This is brilliance of the first order. We must indeed learn to fight/invest on the winning side, and we must be willing to change sides immediately when one side has gained the upper hand.

Once, when Lord Keynes was appearing at a conference he had spoken to the year previous, at which he had suggested an investment in a particular stock that he was now suggesting should be shorted, a gentleman in the audience took him to task for having changed his view. This gentleman wondered how it was possible that Lord Keynes could shift in this manner and thought that Keynes was a charlatan for having changed his opinion. Lord Keynes responded in a wonderfully prescient manner when he said, "Sir, the facts have changed regarding this company, and when the facts change, I change. What do you do, Sir?" Lord Keynes understood the rationality of trading as a mercenary guerrilla, choosing to invest/fight upon the winning side. When the facts change, we must change. It is illogical to do otherwise.

DON'T HOLD ON TO LOSING POSITIONS

R U L E # 4
Capital is in two varieties: Mental and Real, and, of the two, the mental capital is the most important.

Holding on to losing positions costs real capital as one's account balance is depleted, but it can exhaust one's mental capital even more seriously as one holds to the losing trade, becoming more and more fearful with each passing minute, day and week, avoiding potentially profitable trades while one nurtures the losing position.

GO WHERE THE STRENGTH IS

R U L E # 5
The objective of what we are after is not to buy low and to sell high, but to buy high and to sell higher, or to sell short low and to buy lower.

We can never know what price is really "low," nor what price is really "high." We can, however, have a modest chance at knowing what the trend is and acting on that trend. We can buy higher and we can sell higher still if the trend is up. Conversely, we can sell short at low prices and we can cover at lower prices if the trend is still down. However, we've no idea how high high is, nor how low low is.

Nortel went from approximately the split-adjusted price of $1 share back in the early 1980s, to just under $90/share in early 2000 and back to near $1 share by 2002 (where it has hovered ever since). On the way up, it looked expensive at $20, at $30, at $70, and at $85, and on the way down it may have looked inexpensive at $70, and $30, and $20--and even at $10 and $5. The lesson here is that we really cannot tell what is high and/or what is low, but when the trend becomes established, it can run far farther than the most optimistic or most pessimistic among us can foresee.

R U L E # 6
Sell markets that show the greatest weakness; buy markets that show the greatest strength.

Metaphorically, when bearish we need to throw our rocks into the wettest paper sack for it will break the most readily, while in bull markets we need to ride the strongest wind for it shall carry us farther than others.

Those in the women's apparel business understand this rule better than others, for when they carry an inventory of various dresses and designers they watch which designer's work moves off the shelf most readily and which do not. They instinctively mark down the work of those designers who sell poorly, recovering what capital then can as swiftly as they can, and use that capital to buy more works by the successful designer. To do otherwise is counterintuitive. They instinctively buy the "strongest" designers and sell the "weakest." Investors in stocks all too often and by contrast, watch their portfolio shift over time and sell out the best stocks, often deploying this capital into the shares that have lagged. They are, in essence, selling the best designers while buying more of the worst. A clothing shop owner would never do this; stock investors do it all the time and think they are wise for doing so!

MAKING "LOGICAL" PLAYS IS COSTLY

R U L E # 7
In a Bull Market we can only be long or neutral; in a bear market we can only be bearish or neutral.

Rule 6 addresses what might seem like a logical play: selling out of a long position after a sharp rush higher or covering a short position after a sharp break lower--and then trying to play the market from the other direction, hoping to profit from the supposedly inevitable correction, only to see the market continue on in the original direction that we had gotten ourselves exposed to. At this point, we are not only losing real capital, we are losing mental capital at an explosive rate, and we are bound to make more and more errors of judgment along the way.

Actually, in a bull market we can be neutral, modestly long, or aggressively long--getting into the last position after a protracted bull run into which we've added to our winning position all along the way. Conversely, in a bear market we can be neutral, modestly short, or aggressively short, but never, ever can we--or should we--be the opposite way even so slightly.

Many years ago I was standing on the top step of the CBOT bond-trading pit with an old friend Bradley Rotter, looking down into the tumult below in awe. When asked what he thought, Brad replied, "I'm flat ... and I'm nervous." That, we think, says it all...that the markets are often so terrifying that no position is a position of consequence.

R U L E # 8
"Markets can remain illogical far longer than you or I can remain solvent."

I understand that it was Lord Keynes who said this first, but the first time I heard it was one morning many years ago when talking with a very good friend, and mentor, Dr. A. Gary Shilling, as he worried over a position in U.S. debt that was going against him and seemed to go against the most obvious economic fundamentals at the time. Worried about his losing position and obviously dismayed by it, Gary said over the phone, "Dennis, the markets are illogical at times, and they can remain illogical far longer than you or I can remain solvent." The University of Chicago "boys" have argued for decades that the markets are rational, but we in the markets every day know otherwise. We must learn to accept that irrationality, deal with it, and move on. There is not much else one can say. (Dr. Shilling's position shortly thereafter proved to have been wise and profitable, but not before further "mental" capital was expended.)

R U L E # 9
Trading runs in cycles; some are good, some are bad, and there is nothing we can do about that other than accept it and act accordingly.

The academics will never understand this, but those of us who trade for a living know that there are times when every trade we make (even the errors) is profitable and there is nothing we can do to change that. Conversely, there are times that no matter what we do--no matter how wise and considered are our insights; no matter how sophisticated our analysis--our trades will surrender nothing other than losses. Thus, when things are going well, trade often, trade large, and try to maximize the good fortune that is being bestowed upon you. However, when trading poorly, trade infrequently, trade very small, and continue to get steadily smaller until the winds have changed and the trading "gods" have chosen to smile upon you once again. The latter usually happens when we begin following the rules of trading again. Funny how that happens!

THINK LIKE A FUNDAMENTALIST;
TRADE LIKE A TECHNICIAN

R U L E # 10
To trade/invest successfully, think like a fundamentalist; trade like a technician.

It is obviously imperative that we understand the economic fundamentals that will drive a market higher or lower, but we must understand the technicals as well. When we do, then and only then can we, or should we, trade. If the market fundamentals as we understand them are bullish and the trend is down, it is illogical to buy; conversely, if the fundamentals as we understand them are bearish but the market's trend is up, it is illogical to sell that market short. Ah, but if we understand the market's fundamentals to be bullish and if the trend is up, it is even more illogical not to trade bullishly.

R U L E # 11
Keep your technical systems simple.

Over the years we have listened to inordinately bright young men and women explain the most complicated and clearly sophisticated trading systems. These are systems that they have labored over; nurtured; expended huge sums of money and time upon, but our history has shown that they rarely make money for those employing them. Complexity breeds confusion; simplicity breeds an ability to make decisions swiftly, and to admit error when wrong. Simplicity breeds elegance.

The greatest traders/investors we've had the honor to know over the years continue to employ the simplest trading schemes. They draw simple trend lines, they see and act on simple technical signals, they react swiftly, and they attribute it to their knowledge gained over the years that complexity is the home of the young and untested.

UNDERSTAND THE ENVIRONMENT

R U L E # 12
In trading/investing, an understanding of mass psychology is often more important than an understanding of economics.

Markets are, as we like to say, the sum total of the wisdom and stupidity of all who trade in them, and they are collectively given over to the most basic components of the collective psychology. The dot-com bubble was indeed a bubble, but it grew from a small group to a larger group to the largest group, collectively fed by mass mania, until it ended. The economists among us missed the bull-run entirely, but that proves only that markets can indeed remain irrational, and that economic fundamentals may eventually hold the day but in the interim, psychology holds the moment.

And finally the most important rule of all:

THE RULE THAT SUMS UP THE REST

R U L E # 13
Do more of that which is working and do less of that which is not.

This is a simple rule in writing; this is a difficult rule to act upon. However, it synthesizes all the modest wisdom we've accumulated over thirty years of watching and trading in markets. Adding to a winning trade while cutting back on losing trades is the one true rule that holds--and it holds in life as well as in trading/investing.

If you would go to the golf course to play a tournament and find at the practice tee that you are hitting the ball with a slight "left-to-right" tendency that day, it would be best to take that notion out to the course rather than attempt to re-work your swing. Doing more of what is working works on the golf course, and it works in investing.

If you find that writing thank you notes, following the niceties of life that are extended to you, gets you more niceties in the future, you should write more thank you notes. If you find that being pleasant to those around you elicits more pleasantness, then be more pleasant.

And if you find that cutting losses while letting profits run--or even more directly, that cutting losses and adding to winning trades works best of all--then that is the course of action you must take when trading/investing. Here in our offices, as we trade for our own account, we constantly ask each other, "What's working today, and what's not?" Then we try to the very best of our ability "to do more of that which is working and less of that which is not." We've no set rule on how much more or how much less we are to do, we know only that we are to do "some" more of the former and "some" less of the latter. If our long positions are up, we look at which of those long positions is doing us the most good and we do more of that. If short positions are also up, we cut back on that which is doing us the most ill. Our process is simple.

We are certain that great--even vast--holes can and will be proven in our rules by doctoral candidates in business and economics, but we care not a whit, for they work. They've proven so through time and under pressure. We try our best to adhere to them.

This is what I have learned about the world of investing over three decades. I try each day to stand by my rules. I fail miserably at times, for I break them often, and when I do I lose money and mental capital, until such time as I return to my rules and try my very best to hold strongly to them. The losses incurred are the inevitable tithe I must make to the markets to atone for my trading sins. I accept them, and I move on, but only after vowing that "I'll never do that again."

Investing in Gold and Currencies

Speaking of trading, my good friend Chuck Butler at Everbank has a new CD (Certificate of Deposit) whose rate is tied to the increase in the price of gold over five years. It is also 100% principal protected. So if gold for some odd reason goes down, you still get your money back. You get all of the upside and none of the downside and no storage fees or commissions. An FDIC insured way to invest in gold. What will they think of next? You can also invest in dozens of different foreign currencies and earn the interest in the currency as well as the potential gain or loss on the actual currency itself. If you want to diversify your portfolio out of the dollar, Everbank is an easy way to do it. You can get Chuck directly at 800-926-4922. He also writes a free fun daily letter which hits your email box every morning giving you updates on currency movements. (Note: Everbank is a sponsor of my publisher.)

New York and London

Next week, I speak at the "Hedge Fund Incubation and Seeding Conference" on January 30-31 in New York put on by Financial Research Associates. You can get more info at www.frallc.com. I will be in London February 12-16 and then will be back home for over two months before the next planned trips, hoping to get a real jump on writing my next book. Although I know there will be the usual last minute flights here and there. I do need to get to Memphis soon.

Toronto was almost balmy and Miami is very warm and humid. I was quite pleased with the progress we are making in being able to work in Canada. I now have what is known as a Limited Market Dealer in Toronto, which essentially allows my broker dealer to work there. In conjunction with my partners at Pro-Hedge, we are making very good progress in being able to offer the hedge funds and private offerings we work with to Canada. I am meeting in Miami with my new partners EFG and a number of the international team. We will soon be able to work with accredited investors in Latin America, the Mid-East and most of Asia. It is an exciting time and very busy.

If you would like to know more about these services, and of course if you are in the US (where I work with my partners Altegris Investments), you can go to www.accreditedinvestor.ws and see how we help investors. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member NASD.)

It is getting time to go to my next speech. Have a great week!

Your really liking Miami analyst,

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