“For a new age of markets has been ushered in – an age that offers safer opportunities for the reasonable, studious, competent investor and speculator.” – Livermore
In the third chapter of How To Trade in Stocks, Livermore discusses the importance of following the leading stocks in the leading groups. He argues that a speculator needs to be in tune with the general trend of the market and to only follow leading stocks from leading groups so that he is not overwhelmed with unnecessary data.
The Trend Is Your Friend
“It is not good to be too curious about all the reasons behind price movements. You risk the danger of clouding your mind with non-essentials. Just recognize that the movement is there and take advantage of it by steering your speculative ship along with the tide. Do not argue with the condition, and most of all, do not try to combat it.” – Livermore
If you don’t understand what Livermore is talking about here, you can find an example on your TV almost around the clock. If you tune in to one of the business news cable channels at just about any time, day or night, you will find journalists and so-called experts breaking down even the slightest details of the global economy or an individual stock.
Livermore argues that this obsession with analyzing the reason behind a price movement is completely unnecessary. He says that we should simply recognize that there is, in fact, a price movement and align our investments to profit from that movement. This is pretty much the definition of trend following.
Focus Your Investments
“Do not have an interest in too many stocks at one time. It is much easier to watch a few than many.” – Livermore
Here we have another divergence from what the people on TV will tell you. They will tell you that you need to be diversified. That you need to own a “basket of stocks” in many different industry groups in order to make sure you don’t miss out on a big move up and to protect you against any moves down. The problem with diversification is that it spreads you so thin that you are basically just a reflection of the market averages.
Livermore proposes that the speculator should focus his investments in just a few stocks, preferably leaders from strong industry groups. Rather than using diversification to defend against losses, Livermore suggests making sure you are aligned with the major trend to defend yourself.
Follow The Leaders
“Confine your studies of movements to the prominent stocks of the day. If you cannot make money out of the leading active issues, you are not going to make money out of the stock market as a whole.” – Livermore
Stock market leadership can be both a simple and a complex concept at the same time. It is easy to see the logic that following the select few leading stocks in any time period can provide a speculator with outstanding returns and at the same time, paint a clear picture of the general market. It is much more complex to identify those leaders and determine when they are no longer leaders.
One of the ways that I determine leaders is by running multiple screens for various leadership qualities like earnings and sales growth, relative strength, and strong industry group performance. The leading stocks are the ones that seem to show up on most every version of my screens. They will also show up on new highs lists. Watching for these stocks, and paying attention to which stocks are up the most in good market weeks and down the least in bad market weeks is a good starting point to identify leadership.