3 Jesse Livermore Rules for a Fed Taper

NEW YORK (TheStreet) -- Before I discuss the current market outlook, I'd like to summarize a few investment rules made famous by American stock trader Jesse Livermore that are especially pertinent this week:

  1. Pivotal Points. The core of Livermore's timing strategy was built upon two categories of pivotal points. The first he called a reversal pivotal point and the second he called a continuation pivotal point. Optimum buy and sell opportunities occur when an investor is able to identify these key market moments. A speculator has to be patient, Livermore remarked that he always made money when he waited and traded on the confirmation of these pivotal points.
  2. When entering a new trade rooted in a pivotal point thesis, Livermore let the market tell him what to do. He got his clues and cues from what the market told him. He did not anticipate: "To anticipate the market is to gamble; to be patient and react only when the market gives the signal is to speculate." One must be right on the moves but also right on the timing. Therefore, Livermore pioneered the probing strategy similar to a commanding officer sending out a reconnaissance platoon to probe the enemy lines and gather intelligence before unleashing the troops. Averaging into an allocation enables you to avoid pitfalls. If your initial allocation loses 10% it's time to cut losses, admit your mistake, and exit the trade. Averaging in is a sure way to confirm judgement.
  3. If the line of least resistance cannot be identified, it is best to be in cash. The trend is your friend. No trend means get out. Investors should learn to be comfortable in cash.

With these three rules providing a conversational foundation, let's discuss the market outlook.

On Friday we were faced with a potential double whammy of negativity because of Federal Reserve bond purchase tapering on Wednesday and a Larry Summers nomination to Fed chairman by President Obama. Summers was a disaster waiting to happen because of his anti-stimulus bias. The decision to pull his name from consideration provides the stock market with a significant long-term boost.

Jesse Livermore's rulebook would have labeled the Summers catalyst as a reversal pivotal point; however, with Fed official Janet Yellen now in the picture, the status quo is reaffirmed and Obama's Fed appointment catalyst simply becomes a continuation pivotal point which reinforces the long-term bullish trend.

In the short run we still have to deal with the second half of the double whammy, which is the beginning of a Fed taper. The media is referring to it as a "tiny taper" of only $10 billion so it shouldn't be too much of a shock to our economic sentiment, especially in the absence of Summers. Nevertheless, it is a noteworthy pivotal point that should be recognized with a negative bias. This is why we have more than 90% of the portfolio in cash.

Until the technical action proves otherwise, I will remain cautious in the short run. If this catalyst snowballs into a reversal point it would impact upon leaders such as Google ( GOOG), Tesla ( TSLA) and Priceline ( PCLN) -- three leadership stocks that have experienced strong technical resistance in recent weeks at $890, $170 and $980, respectively. Netflix ( NFLX) is also an interesting breakdown candidate at $300, if this taper turns into a reversal pivotal point.

Of course, the other play to watch is gold. Monday the metal finished at $1,311, even with the news that Summers is out. If Tuesday is down again, we'll buy more of the SPDR Gold Trust ( GLD) January 2014 $135 puts that have performed so well so far.

Recent positive market action that has boosted the Dow Jones Industrial Average all the way back to 15,500 because of good news from Syria, and Summers has yet to recognize the reality of the taper. We will learn a lot from the broad market action of the next five trading days as the taper finally becomes the market's singular focus. Either it's a reversal pivotal point or it's a continuation pivotal point.

Until we get a definitive answer, we'll probe the short side of GOOG/TSLA/PCLN/GLD and hold the majority of the portfolio in cash. After enjoying the previous $97 Apple ( AAPL) Apple run we are certainly comfortable to be in cash as the market signals its next move.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Jason Schwarz is an option strategist for Lone Peak Asset Management in Westlake Village, Calif. He is also the founder of the popular investment newsletter available at www.economictiming.com. Over the past few years, Schwarz has gained acclaim for his market calls on the price of oil, Bank of America, Apple, E*Trade, and his precision investing in S&P 500 option LEAPS. His book, The Alpha Hunter, is set to be released by McGraw Hill in December 2009.

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