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January 4, 2010

Jesse Livermore, Efficient Market Hypothesis and Polynesian Navigators

Jesse Livermore's 1940 book, How to Trade In Stocks, is very interesting reading for traders, speculator and investors alike. In brief, Livermore says that markets behave in certain predictable ways (up to a point) and that observant speculators can take advantage of this predictability. Of course, this is the exact opposite of what the Efficient Market Hypothesis holds. I'll get to that in a minute but first I want to discuss how some of Livermore's ideas were later confirmed by academics, although never, to my knowledge, acknowledged, probably because the academics never read Jesse Livermore.

One interesting point is that Benoit Mandelbrot has shown that price fluctuations are fractal, meaning that as you change scale, the character of the price chart stays the same. In other words, a minute by minute chart would look the same as a daily chart or a weekly chart. Fractals were invented long after Jesse Livermore died but what is interesting is that he intuitively knew that prices were fractal and in his writing suggested ignoring the small and intermediate wiggles and to concentrate on larger price moves to take advantage of the big market moves.

The passage that really grabbed my interest follows. After discussing price movements in steel, Livermore tells about the news that caused the price break and comments:
This incident proves the folly of trying to find out "a good reason" why you should buy or sell a given stock. If you wait until you have the reason given you, you will have missed the opportunity of having acted at the proper time! The only reason an investor or speculator should ever want to have pointed out to him is the action of the market itself. Whenever the market does not act right or in the way it should -- that is reason enough for you to change your opinion and change it immediately. Remember: there is always a reason for a stock acting the way it does. But also remember: the chances are that you will not become acquainted with that reason until some time in the future, when it is too late to act on it profitably.
Here is my interpretation of the passage:

Markets, or prices, are an information system designed to inform buyers and sellers about supply and demand. Price will rise or fall as needed to clear the market. Speculators are not "real" buyers or sellers in that they neither produce nor consume the quoted items. Speculators just want to take advantage of the temporary market anomaly. Some say this activity is evil while others say it adds liquidity to markets but that is the subject for another discussion.

In brief, the Efficient Market Hypothesis holds that markets are so efficient that by the time you get the news that moved the market, it is too late for you to act on these news, the news have already been baked into the price. Jesse Livermore agrees with this observation, he states: "But also remember: the chances are that you will not become acquainted with that reason until some time in the future, when it is too late to act on it profitably." But he does not agree with the conclusion drawn by academics that a speculator cannot take advantage of the market anomalies.

Jesse Livermore held that when news hit the market they generate waves or price patterns that observant speculators can detect and act upon profitably even when they don't know what the news that set up the price pattern was. In other words, the speculator does not act on the news per se, but on the effect of the news on prices since the price movements arrive ahead of the news themselves! This is really interesting because Livermore confirms the Efficient Market Hypothesis while at the same time he shows how academics still draw the wrong conclusion.

The strangest part of the tale is that I have received confirmation from half way around the world, from a breed of professionals that are practically extinct: the Polynesian Navigators! The South Pacific is the world's largest ocean and it is dotted with islands. A Polynesian unfamiliar with the Polynesian navigation system would not be able to find his way from one island to the next, he would, literally, be lost at sea. Not so the Polynesian Navigators. Their island finding method relies on careful observation of signs such as birds and wave patterns. These signs are set up by the unseen islands, in other words, by the news unknown to the speculator. But the signs are real, for example, shortly before nightfall the birds stop fishing and circling and fly home thereby indicating where land lies.

By the way, Jesse Livermore's writing style is very clear and concise. I have read many books about investing and speculating and How to Trade In Stocks is a delight to read.

Denny Schlesinger


Efficient Market Hypothesis - EMH
How to Trade In Stocks, PDF book Jesse Livermore
We, the Navigators: The Ancient Art of Landfinding in the Pacific David Lewis

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