Jesse Livermore – The Search for the Truth with the Anonymous Master - [Invest Like the Best, EP.136]

Here is the English translation of the provided Chinese investment research notes, following all specified rules.

At a Glance

The guest on this episode is an anonymous financial researcher using the pseudonym Jesse Livermore, currently a research partner at OSAM. Combining a background in physics and philosophy, he explores three thinking tools for investment research (intuition, analysis, and statistical inference) and delves into the distorting effects of inflation on market valuations, the earnings illusion, the potential risks of trend-following strategies, and the intrinsic mechanisms of value and momentum factors. Jesse Livermore argues that due to Federal Reserve intervention, a slowing economic cycle, and prolonged low inflation, future market "crashes" may become less frequent, posing a fundamental threat to trend-following strategies that rely on large drawdowns for profitability.

Topic Sections

1. Three Tools for Investment Research: Intuition, Analysis, and Statistical Inference

Jesse Livermore believes that effective investment decisions require integrating three methods—intuition, analysis, and statistical inference—but each has its own applicable scenarios and inherent flaws.

• Intuition: Low cost and fast, but relies on experience accumulated in high-validity environments. Financial markets are noisy, a "hostile" environment where intuition is prone to error. Jesse cites a 2011 cognitive reflection study, noting that individuals with high cognitive reflection ability can use intuition better, but excessive reflection (over-analysis) is equally harmful—analysis is suitable for "laying out information," but ultimately "pulling the trigger" still relies on intuition.
• Analysis: Deductive reasoning based on principles and models, relatively low cost, capable of handling novel situations like "regime changes" with no historical data, and the process is transparent. However, its fatal flaw is being "extremely prone to error"; missing just one key variable can collapse the entire conclusion. Jesse emphasizes that when using analysis, one must "build in a margin of safety" and proactively conduct stress tests to find weaknesses.
• Statistical Inference: Tests hypotheses through data, directly contacting reality, and is a powerful tool for validating analytical conclusions. But its foundation (Bayesian reasoning) is easily "corrupted." Jesse points out common pitfalls include: confusing "sample size" with "number of trials" (e.g., mistaking correlated data points for independent trials), multiple comparisons (continuously adjusting hypotheses until a significant pattern is found), and ex-post selection bias (developing theories from historical data rather than "calling your shot"). The solution is to insist on "calling your shot": have a theory first, then test it out-of-sample using data from different markets and time periods.

2. The "Earnings Illusion": How Inflation Distorts Accounting Profits and Market Valuations

Using an "Integrated Equity" model, Jesse Livermore reveals that because historical cost accounting systematically understates depreciation in an inflationary environment, accounting profits are systematically overvalued, distorting traditional price-to-earnings ratios (like CAPE) in historical comparisons.

• Mechanism: US GAAP calculates depreciation based on historical cost. During periods of high inflation, the replacement cost of assets is far higher than the historical cost, but depreciation expense is still booked at historical cost, leading to overvalued profits. Jesse points out this is a key reason for the extremely low P/E ratios in the early 1980s—the market "very cleverly" identified the inflated profits and marked down the valuation multiple.
• Data Validation: Jesse's "Integrated Equity" model (which sums inflation-adjusted retained earnings over the years as "true" book value) shows that the return on equity (ROE) calculated this way is only about 4%, far lower than traditional accounting data. This confirms that retained earnings have not generated the expected returns, as a large portion merely compensates for depreciation eroded by inflation.
• Importance of Free Cash Flow: Unlike accounting profit, free cash flow (FCF) directly reflects the cash a company can actually deploy. Jesse finds that during high inflation, FCF drops significantly, perfectly supporting the argument that "profits are overvalued." Therefore, free cash flow is a more reliable valuation signal than accounting profit.

3. Concerns for Trend Following and "Growth Trend Timing"

Jesse Livermore expresses an "agnostic" concern about the future of traditional trend-following strategies, arguing that their historical returns heavily depend on a few extreme bear markets, and future changes in market structure could render them ineffective.

• Source of Returns: The profit model of trend strategies is "using small losses (frequent false signals) to exchange for the opportunity to avoid large drawdowns (like 2008)." Their excess returns come almost entirely from a few deep, prolonged bear markets.
• Future Risk: Jesse believes that due to active Fed intervention, a slowing economic cycle, and prolonged low inflation, future markets may exhibit "more false signals and fewer big crashes." If this judgment holds, trend strategies will underperform due to being frequently "whipsawed" by false signals.
• Attempted Improvement: To address this risk, Jesse proposes a "Growth Trend Timing" strategy, which only activates trend signals when there is a high-probability recession signal. The economic indicators he identifies as effective include: real retail sales, industrial production, housing starts, and the unemployment rate trend. However, he admits the statistical evidence for this strategy is weak (small sample size), posing a significant risk of overfitting.

4. "Dissecting" Value and Momentum Factors: Completely Different Sources of Returns

Jesse Livermore decomposes stock returns into "fundamental growth" and "valuation multiple expansion," using this to dissect the intrinsic mechanisms of value and momentum factors, finding their return sources are entirely opposite.

• Value Factor: The market's pessimistic expectations for value stocks (low P/E) are often excessive. After buying, company earnings initially decline as expected, but eventually "recover" in the long run, ultimately providing cumulative earnings higher than the purchase cost. Excess returns mainly come from valuation multiple expansion, i.e., the process of the market correcting its overly pessimistic expectations.
• Momentum Factor: After buying, momentum stocks experience "extraordinary earnings growth," and the market is actively pricing this in. However, Jesse finds that after selling the stock to the next person at the end of the holding period, the buyer significantly underperforms. This suggests that momentum strategy returns come from the market's excessive optimism at the end of a cycle; investors are selling the stock to a buyer who is "making a mistake." Jesse believes value investing aligns more with the logic of "the market correcting errors," while momentum investing involves "exploiting the market's creation of errors."

Position Moves

Ticker/Asset	Guest's Stance	Key Data
Union Electric Preferred Stock	As a case of market inefficiency	Issued in 1946, yield 3.85%, while the same company's 40-year senior mortgage bond yielded only 3.55%, a severe risk-return inversion.
Alcoa (Arconic) Preferred Stock	As a case of market inefficiency	Issued in 1947, yield 4.25%, while the same company's senior bond yielded 5.76%, investors taking higher risk for lower return.
Best Buy (Example)	As a case of value stock	A retail stock "hammered" by the market, its low P/E ratio reflects market expectations of future earnings decline.

Judgments Worth Remembering

1. Jesse Livermore argues that "pulling the trigger" on an investment decision ultimately relies on intuition, not analysis. Analysis is good at "laying out information" but cannot make the final choice; over-analysis leads to decision paralysis, and one must rely on trained intuition for the "final kick."

2. Jesse Livermore points out that the foundation of statistical inference (Bayesian reasoning) is easily corrupted by "multiple comparisons" and "ex-post selection." With powerful computing capabilities today, investors can easily "mine" spurious patterns that are pure noise from data, and "calling your shot" (having a theory first, then testing) is the only antidote.

3. Jesse Livermore believes that long-term comparisons of market valuations (like CAPE) are distorted by inflation's impact on accounting profits. The low P/E ratios of the early 1980s were not because the market was extremely cheap, but because high inflation led to understated depreciation and overstated profits, causing the market to "cleverly" mark down multiples.

4. Jesse Livermore judges that future markets will be "more expensive" and "more stable," and investors should lower return expectations. His logic: Fed intervention, economic structural maturation, and prolonged low inflation collectively reduce market "liquidity risk" and "panic risk," thereby compressing the equity risk premium and making high valuations the new normal.

5. Jesse Livermore holds an "agnostic" view on the future of trend-following strategies, arguing their historical returns heavily depend on a few extreme bear markets. He warns that if future markets have "many false signals and few big crashes," trend strategies will fail due to frequent "whipsaws."

6. Using his "Integrated Equity" model, Jesse Livermore finds that the "true" return on equity (ROE) for the US corporate sector is only about 4%. This reveals that accounting profits are systematically overvalued, as a large portion of "retained earnings" merely compensates for depreciation eroded by inflation, creating no real value.

7. Jesse Livermore proposes that the excess returns of the value factor come from "market error correction after excessive pessimism," while the excess returns of the momentum factor come from "passing the baton after excessive market optimism." The former involves buying an asset being mispriced and waiting for its value to return; the latter involves buying an asset that may already be fairly priced and selling it to an even more optimistic buyer.

8. Jesse Livermore proposes the "transmission method" to foster genuine dissent within organizations. He believes public debate suppresses differing opinions due to "status costs." A more effective method is to have everyone submit their objections privately to the decision-maker, who then consolidates them and communicates with the proposer, thereby eliminating political concerns while preserving the motivation to express dissent.