Scientific stock speculation

Contents

Chapter Page

Introduction 5

I. Scientific Speculation 1 1

Introduction

By G. C. Selden

MR. CHARLES H. DOW, formerly the head of the Dow-Jones News Bureau, Wall Street's largest news gathering agency, had unusual opportunities for observing the methods of traders in stocks, both successful and unsuccessful. And it may be added that at the time of his death it was found that he had profited substantially by his accumulated knowledge.

About the year 1902 he wrote for the Wall Street Journal a series of articles on the science of stock speculation which attracted much attention. They were reprinted in book form, but the book has long been out of print. These articles are here reproduced just as he wrote them.

A good deal of water has flowed under the bridge since 1902, but there has been no change in the essential principles which Mr. Dow 7 laid down. This is in itself a strong tribute to their permanent value, when we consider the great changes that have taken place not only in the stock market itself but in the country at large, in banking methods, in the promotion and sale of new securities, in the personnel of Wall Street and so on.

In 1902 the railroad stocks were the principal part of the market. They were the favorites not only with investors but with speculators also. The U. S. Steel Corporation had been organized the previous year, the stock had been well distributed to investors, and in 1904 it sold below $10 a share. Other industrials passed through a similar experience and were for the most part regarded questioningly. *

This, it will be remembered, was before the heyday of Harriman. Even two years later, in 1904, Union Pacific sold at 71, and it was not until 1909 that its high price of 219 was reached. Only 4% dividends were paid on it in 1902.

The days of big speculation and wide price changes in industrial stocks had not then arrived. The few stocks which sold at very high prices were of an investment character and had an inactive market. The active speculation was in medium and low-priced issues.

It is important to bear these differences in mind in order to get the full grasp of Mr. Dow's idea. If he were writing today, he would not make any essential changes in the principles laid down ; but he would probably modify some of his statements and would present a wider range of illustrations of the application of his methods to different classes of securities.

I have not been willing to tamper with a text so clear, succint and well worded, but have added some notes, in order to call attention to some of the more important changes in conditions and market customs which have taken place since Mr. Dow wrote.

There are many, of course, who will quarrel with the title of this book, "Scientific Stock Speculation/' on the ground that speculation can never be reduced to a science. It is true that it cannot be reduced to a mathematical science, but it is certainly entitled to be called a science in the same sense that economics is a science.

Science in speculation must deal with tendencies rather than with exact mathematical conclusions. It is very noticeable that those who are most successful as investors for profit are usually of the type of the business man rather than the trained student of mathematics. The mathematician is always seeking some invariable rule or fundamental principle of fluctuations. This he cannot find. All speculative rules musl be approximate. Any rule may be upset by the sudden development of new conditions.

To take as an example the old problem of the man rowing a boat directly across a river in a high wind : The mathematician, if given the rower's rate of speed, the rate of flow of the river, and the effect of the wind on the boat, can resolve these forces and show how far down the river the landing will be at the other side.

But to resolve the forces which control the price of a stock, a hundred different influences might have to be taken into account, some important and some slight, all varying constantly in the amount of their effect, and with the everrecurring possibility of some new force appearing which would be temporarily more powerful than all the others put together.

Clearly this constitutes a problem beyond the reach of mathematics. Yet it is quite possible to estimate the importance of the principal elements in the situation ; to make reasonable allowances for the possibility of some new factor entering in; to see in advance some of the changes which are impending; and to adjust the available capital to the character of the opportunity by means of the principle of averaging in some form, so that results are obtained which may properly be called scientific in a correct sense of that word.

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Mr. Dow brings out very clearly the two wavs in which the principle of averaging is employed in speculation :

(i) By buying small lots of a stock at fixed price intervals as it declines, and

(2) Taking small losses when wrong and calculating for a certain average of correctness; that is, for being right three times out of five, or four times out of seven.

While the two plans are diametrically opposite in practice, both are based on the idea of averaging. It is probably safe to say that nine out of ten successful speculators make use of this principle of averaging in some form.

The chapter on 'The Recurrence of Crises" is, of course, intended merely as a brief sketch of the subject. It is evident that Mr. Dow had not devoted much attention to the study of trade cycles. In fact, most of the progress in making practical use of the idea of cycles has been made since he wrote.

Methods of trading which stand the test of twenty years without the necessity of any important revision necessarily command respect, and it is probably not too much to say that no one should begin his stock market experience without having absorbed, from some source or other, the ideas which Mr. Dow presents so briefly and clearly in* this book.

CHAPTER I. Scientific Speculation

THE question whether there is such a thing as scientific speculation is often asked. Various answers of a somewhat affirmative character have been given but they have generally been hedged about with so many qualifications as to be nearly useless for practical purposes. The experiences of operators have, however, crystallized into some general rules worth heeding. -*.

The maxim "buy cheap and sell dear" is as old as speculation itself, but it leaves unsolved the question of when a security or a commodity is cheap and when it is dear, and this is the vital point.

The elder Rothschilds are said to have acted on the principle that it was well to buy a property of known value when others wanted to sell and to sell when others wanted to buy. There is a great deal of sound wisdom in this. The public, as a whole, buys at the wrong time and sells at the wrong time. The reason is that markets are made in part by manipulation and the public buys on manipulated advances and after they are well along. Hence it buys at the time when manipulators wish to sell and sells when manipulators wish to buy. {See Note I.)

Note 1. — It is probable that Mr. Dow had in mind the manipulation of a single stock or group of stocks, rather than of the market as a whole. The whole market taken together is too big to be successfully handled by any manipulator or group of manipulators. This, in fact, grows less and less possible every year as the numbers of securities and of' investors increase.

On the other hand, it is naturally in times when the public becomes enthusiastic that various manipulators are busy in different issues, so that near the climax of a big bull market manipulation affects a larger number of issues than at other times, and thus the general average of prices may be said to be partly dependent on manipulation.

But the fact should be remembered that both the public enthusiasm and the manipulation which accompanies it are the results of the conditions which made the bull market possible. Instances of manipulation purely at the will of some individual or group, regardless of current or prospective changes in actual conditions affecting values, are becoming more rare year by year, since it becomes more and more difficult to make such manipulations profitable.

In some commission offices, there are traders who, as a rule, go against whatever the outside customers of the house are doing. When members of the firm say, "all our customers are getting long of stocks/ 1 these traders sell out; but they buy when the firm says, "the customers are all short." There are, of course, exceptions to this rule. If there were no exceptions, the keepers of bucket shops w r ould all get rich. When the market has an extraordinary rise, the public makes money, in spite of beginning its purchases at what would ordinarily be the wrong time, and this is when the bucket shops either lose their money or close out in order to keep such money of customers as they have in hand.

All this points to the soundness of the Rothschild principle of buying a property of known value when the public generally is disposed to sell ; or of selling it when the public thinks it a time to buy.

Daniel Drew used to say, "cut your losses short, but let your profits run." This was good preaching, but "Uncle Dan" did not, in his later years, practice this rule, when it would have been better for him if he had. The thought here is unquestionably one of the sound principles in trading. It means that if a stock has been purchased and it goes up, it is well to wait; but if it goes down, it is well to stop the loss quickly on the ground that the theory on which the purchase was made was wrong.

The public, as a whole, exactly reverses this rule. The average operator, when he sees two or three points profit, takes it ; but if a stock goes against him two or three points, he holds on waiting for the price to recover, with, oftentimes, the result of seeing a loss of two or three points run into a loss of ten points. He then becomes discouraged and sells out near the bottom to protect the margin which he has left.

How many operators in looking over their books find a considerable number of small profits swept away by one large loss? When a trader finds by his accounts that his profits have been relatively large and his losses relatively small, he can make up his mind that he is learning how to trade.

The trouble with carrying out this plan i that a series of losses of from iy 2 to 2 points are very discouraging. A trader who sees that he has taken twice or three times a loss of two points when, if he had waited a few days he need not have taken any loss, is very apt to decide that he will not cut his losses short any more but will wait, and this is the time when the recovery does not come.

SCIENTIFIC STOCK SPECULATION. I 5

Mr. Jay Gould said his policy was to endeavor to foresee future conditions in a property and then, having made his commitments carefully, to exercise great patience in awaiting results. This also is sound doctrine, but proceeds along very different lines. Assuming the ability to foresee the future, it is the wisest of all courses ; but many who have tried this method have found that the omission of essential factors made thenforecast valueless, and both their courage and their patience of little avail. Nevertheless, this method should not be discarded on account of the difficulties involved. Within limitations, the future can be foreseen. The present is always tending toward the future and there are always in existing conditions signals of danger or encouragement for those who read with care.

CHAPTER II. The Two General Methods of Trading

THERE are two general methods of trading. One is to deal in active stock in comparatively large amounts, relying for protection upon stop orders. In this method of trading it is not necessary to know much about the values. The point of chief importance is that the stock should be active enough to permit the execution of the stop order at the point selected so as to cut ses short. The operator, by this method. guesses which way the stock will move. If he guesses right, he lets his profits run. If he wrong, he goes out on the stop order. If he can guess right as often as he can guess wrong he is fairly sure of profits.

The other system is an entirely different proposition. It starts with the assumption that the operator knows approximately the value of the stock in which he proposes to deal. It assumes that he has considered the tendency of the general market ; that he realizes whether the stock in which he proposes to deal is relatively up or l8 SCIENTIFIC STOCK SPECULATION.

down, and that he feels sure of its value for at least months to come.

Suppose this to exist: The operator lays out his plan of campaign on the theory that he will buy his first lot of stock at what he considers the right price and the right time, and will then buy an equal amount every i per cent, down as far as the decline may go.

This method of trading is the one generally employed by large operators. They know the value of the stock in which they propose to deal, and are therefore reasonably secure in following a decline. They feel about a stock as merchants feel about buying staple goods. If an article is cheap at $100, they know it is cheaper at $90, and will strain a point to buy at $80 or at $70, knowing that the price must recover. This is the way a large operator looks at his favorite stocks and this is why he generally makes money in them.

The disadvantage of the small operator in following this method is two-fold. He does not absolutely know the value of the stock. That is, he may know the truth up to a certain point, but beyond that is an unknown factor which interferes with the result. When the price of a stock declines considerably, the small operator always fears that he has overlooked something

SCIENTIFIC STOCK SPECULATION. IQ

of importance, and he is therefore tempted to sell instead of averaging his holdings.

The second disadvantage of the small operator in following this policy is that he seldom provides sufficient capital for his requirements. Thousands of speculators believe that because 10 per cent, is a common speculative margin, $1,000 justifies them in trading in hundred share lots. This impression produces losses continually.

The man who has $1,000 for speculation is not well equipped for trading in even 10 share lots, if he proposes to deal on a scale. A comparison of high and low prices of active stocks shows frequently a difference of 30 points in a year. Any operator proposing to follow a stock down, buying on a scale, should make his preparations for a possible fall of from 20 to 30 points. Assuming that he does not begin to buy until his stock is 5 points down from the top, there is still a possibility of having to buy 20 lots before the turn will come.

If, however, an outsider will provide $2,500, as his speculative capital and will trade in ten-share lots in a thoroughly good railroad stock, beginning his purchases only after a decline of five points in a rising market, and ten points in a bear market, following the decline with purcha>es every point down, and retaining all the stock bought, he seldom need make a loss. (See Note 2.)

Such campaigns require time, patience, and the pursuance of a fixed policy, but whoever will follow this policy will find himself able to get a high rate of interest on the capital invested.

1/ It is an old saying in Wall Street that the man - who begins to speculate in stocks with the intention of making a fortune, usually goes broke, whereas the man who trades with a view of getting good interest on his money, sometimes

A gets rich.

This is only another way of saying that money is made by conservative trading rather than by the effort to get large profits by taking large

* risks. After allowing for all the risks involved, we think the outsider who wants to trade in

Note 2. — There has been a great change in the character of the market since these paragraphs were written. What Mr. Dow said is still true of a large number of low and medium priced stocks which have sound investment value behind them. But many other issues, selling at a higher price or having a more speculative character, now have much wider fluctuations than those here mentioned and would require a correspondingly larger capital in proportion to the number of shares bought.

stocks has a better chance working in small lots on a scale than in any other way, provided he will pay attention to certain essential points, which for convenience of reference we will enumerate in order.

i. — Bull markets and bear markets run four and five years at a time. Determine by the average prices, which one is under way. (See Note

2. — Determine the stock or stocks to trade in. They should be railroad stocks, dividend payers, not too low, nor too high, fairly active, and for the bull side below their value; for the bear side above their value. Values are determined roughlv bv the earnings available for dividends. (See te. 4.)

3. Observe the position of your stock with relation to recent fluctuations. In a bull market,

re 3. — In recent years the average duration of bull and bear markets has been shorter than here indicated. "Tidal Swings of the Stock Market," by Scribner Browne, published bv The Magazine of Wall Street.

TE 4. — At the time this was written the industrial issues were comparatively new and were regarded as more speculative than the rails. Industrial stocks suited to this purpose could now be ^elected.

the time to begin to buy is when a stock has had four or five points decline from the last previous top. In a bear market, the time to begin to sell is when such a stock has had three or four points rally from the bottom.

4. — Stick to the stock bought until a fair profit or until there is good reason for deciding that the first estimate of value was wrong. Remember that an active stock will generally rally from three-eighths to five-eighths of the amount of its decline under adverse conditions and more than that under favorable conditions.

5. — Have money enough to see a decline through without becoming uneasy or over-burdened ; $2,500 ought to take care of a ten-share scale every point down — that is to say, supposing the first lot to be bought five points down from the top, $2,500 ought to carry the scale until the natural recovery from the low point brings the lot out with a profit on the average cost. It will not do to expect a profit on every lot, but only on the average. In a bull market it is better to always work on the bull side; in a bear market, on the bear side. There are usually more rallies in a bear market than there are relapses in a bull market. {See Note 5.)

Note 5. — As affecting more recent markets, this statement seems open to question.

S< tENTIFIC STOCK SPECULATION. 23

6. — Do not let success in making money in ten-share lots create a belief that a bolder policy will be wiser and begin to trade in 100-share lots with inadequate capital. A few hundred-share losses will wipe out a good many ten-share profits.

7. — There is not usually much difficulty in dealing in ten-share lots on the short side. If one broker does not wish to do it, another probably will, especially for a customer who amply protects his account and who seems to understand what he is doing.

CHAPTER III. Thrfe General Lines of Reasoning

WE have spoken in a preceding article of the fact that the experience of great interests in the market seems to have crvstalized into three general lines of reasoning.

The first is that the surface appearance of the market is apt to be deceptive. The second is that it is well in trading to cut losses short and let profits run. The third is that correctly discounting the future is a sure and easy road to wealth. The problem is how these rules which are undoubtedly sound, can be operated in a practical way.

Let us take first the action of the general market with reference to the time to buy. The market is always to be considered as having three movements, all going on at the same time. The first is the narrow movement from day to day. The second is the short swing, running from two weeks to a month or more; the third is the main movement covering at least four years in it- duration. (See Xote 3, p. 21.)

The day to day movement should be disregarded by everybody, except traders who pay no commissions. The medium swing is the one for ordinary consideration. The outside trader should not attempt to deal in more than two or three stocks at a time. He should keep a chart of the price movements of these stocks so as to know their swings for months or years, and thus be able to tell readily where in the general swing his particular stocks appear to be.

He should keep with his price movement a record of the volume of transactions and notes of any special facts bearing on that property, such as increases or decreases in earnings, increases in fixed charges, development of floating debt, and above all the actual earnings available for dividends as shown from month to month. He should observe the movement of the general market as indicated by the average published daily, as this shows the market more clearly than it is shown by any one stock. {See Note

The main purpose of this study is to enable

the trader to determine, first, the value of the

Note 6. — Daily averages of the market are now published by various newspapers. Among the best are those of the New York Times and the Wall Street Journal.

SCIENTIFIC STOCK SPECULATION. 2J

stock he is in ; whether it is increasing or decreasing and, second, when the time to buy seems opportune. Assuming the thirty day swing to be about five points, it is in the highest degree desirable not to buy when three of these points have passed, as such a purchase limits the probable profit to about two points.

It is therefore generally wise to look for a low point on a decline. Suppose, for instance, that Union Pacific was the stock under consideration; that it was clearly selling below its value, and that a bull market for the four-year period was under way. Assuming further that in a period of reaction Union Pacific had fallen four points from the previous highest. Assume earnings and prospects to be favorable and the outlook for the general market to be about normal. (See Xote 7.)

This would be the time to begin to buy Union Pacific. The prudent trader, how r ever, would take only part of his line. He would buy perhaps one-half of the stock he wanted and then give an order to buy the remainder as the price declined. The fall might go much further than he anticipated. It might be necessary to wait

Mote 7. — Written, of course, before the excited fluctuations of Union Pacific, under the Harriman me.

a long time for profit. There might even be developments which would make it wise to throw over the stock bought with the hope of replacing it materially lower.

These, however, are all exception**. In a majority of cases this method of choosing the time to buy, founded upon clear perception of value in the stock chosen and close observation of the market swings under way will enable an operator to secure stock at a time and at a price which 'will give fair profits on the investment.

CHAPTER IV. Swings Within Swings

A CORRESPONDENT asks: "For some time you have been writing rather bullish on the immediate market, yet a little bearish in a larger sense. How do you make this consistent?"

We get this question in one form or another rather frequently. It denotes a lack of familiarity with fluctuations in prices when viewed over considerable periods. Many people seem to think that the change in prices in any one day is complete in itself and bears no relation to larger movements which may be under way. This is not so.

Nothing is more certain than that the market has three well defined movements which fit into each other. The first is the daily variation due to local causes and the balance of buying or selling at that particular time. The secondary movement covers a period ranging from ten days to sixty days, averaging probably between thirty and forty days. The third move is the great swing covering from four to six years.

In thinking about the market, it is necessary to think with reference to each of these periods in order to take advantage of opportunities. If the main move is up, relapses are speculators' opportunities, but if the main move is down, rallies furnish these opportunities.

Losses should not generally be taken on the long side in a bull period. Nor should they generally be taken on the short side in a bear period. It is a bull period as long as the average of one high point exceeds that of previous high points. It is a bear period when the low point becomes lower than the previous low points. It is often difficult to judge whether the end of an advance has come because the movement of prices is that which would occur if the main tendency had changed. Yet, it may only be an unusually pronounced secondary movement.

The first thing for any operator to consider is the value of the stock in which he proposes to trade. The second is to determine the direction of the main movement of prices. We know of nothing more instructive on this point than the course of prices as printed daily. The third thing is to determine the position of the secondary swing.

Assume for instance that the stock selected was Union Pacific; that the course of prices

SCIENTIFIC STOCK SIUXl'LATION. 31

afforded clear evidence of a bull market under way ; that the high point in Union Pacific thirty days ago was 10S; that the price had slowly declined in sympathy with the market and without special new features to 98. The chances would he in favor of buying a part of the line wanted at that price with the intention of buying a little more if the stock had further decline or if the price showed a well defined advancing tendency. It would then be wise to watch the general market and wait for an advance.

A 10-point decline under such conditions would be almost certain to bring, in a bull market, more than five points recovery and full ten points would not be unreasonable ; hence if the general market maintained a good tone, it w r ould be wise to wait for five points and then begin to think about stop orders.

Even in a bear market, this method of trading will be usually be found safe, although the profit taken should be less because of the liability of weak spots breaking out and checking the general rise.

CHAPTER V. Methods of Reading the Market

A CORRESPONDENT writes: "Is there any way of forecasting the course of the market from the tape, from your records of transactions or from the summarized movement of prices? Transactions must mean something, but how can a trader tell what they mean?" This is an old question. There have been a variety of answers but it is doubtful if any have been or can be wholly satisfactory. Several methods, however, are in practical use and at times afford suggestions.

There is what is called the book method. Prices are set down, giving each change of one point as it occurs, forming thereby lines having reneral horizontal direction but running into diagonals as the market moves up and down. There come times when a stock with a good degree of activity will stay within a narrow range of prices, say two points, until there has formed quite a long horizontal line of these figures. The formation of such a line sometimes suggests that k has been accumulated or distributed, and 33 this leads other people to buy or sell at the same time. Records of this kind kept for the last fifteen years seem to support the theory that the manipulation necessary to acquire stock is oftentimes detected in this way.

Another method is what is called the theory of double tops. Records of trading show that in many cases when a stock reaches top it will have a moderate decline and then go back again to near the highest figures. If after such a move, the price again recedes, it is liable to decline some distance.