Dennis Gartman’s Eighth Rule of Trading: a commentary

Dennis Gartman’s eighth rule of trading:  “Markets can remain illogical far longer than you or I can remain solvent” (quote attributed to J. M. Keynes)

This depends on the definition of the term “solvency”.  As a function of the solvency ratio, one must be pulling a profit at all times.  However, I assume that Gartman probably means something like this:

The financial ability to pay debts when they become due. The solvency of a company tells an investor whether a company can pay its debts.

The way Dennis Gartman-type trader would become insolvent is through a margin call that could not be met.  But Gartman says never to meet a margin call but rather liquidate positions.  But what if selling assets is insufficient?  The margin account could end up in a negative position and the trader becomes insolvent.  Gartman’s advice is good as far is it goes.  If a trader bets on a position using margin and leverage, he has to know when to leave the position before becoming insolvent.  Say you’ve shorted Berkshire Hathaway because you know that “idiot” is running that company to the ground:  when the irrational market keeps bidding that stupid company to the sky, you better get the heck out of that position before it bankrupts you.  That’s excellent advice.

But wouldn’t it be better to use leverage in a way that leadeth not unto insolvency?  So here is my alternate rule:

Thou shalt not use leverage unto insolvency

Lehman Brothers and Bear Stearns are the negative parables of times–investment banks so highly leveraged that they couldn’t withstand a downturn in the economy.  They had established debt-to-equity ratios of 30 or more to one.  A company or individual that keeps the debt to equity ratio at a more manageable level will not likely go bankrupt except during an Armageddon of deflationary meltdown, if the country loses a war on its own soil, or if communists come to power and seize all wealth.  Warren Stephens, in a Forbes interview, said that his investment bank only leveraged at 2-1, because he learned that one of the most important goals of business is to be in business tomorrow.  I am personally only comfortable with a debt-to-equity ratio of 1 or less.  Moreover, it is not a good idea to depend on available margin alone, unless that margin is extremely ample.  When the stock market crashes, margin credit also plummets.  Therefore, it is good to have a line of credit (e.g., HELOC) to fall back on.  Indeed, for the selling of puts covered by the margin, I immediately subtract the cost of assignment from the available line of credit, while reserving at least half of the line of credit for averaging down.  So it is ok in my opinion to use leverage; it just must be managed in a conservative manner.

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