Trend Following. Ritholtz Barry

genius, and it was a mistake (laughter). The fundamentals of this nation are strong. One of the interesting developments has been the role of exports in overall GDP growth. When you open up markets for goods and services, and we’re treated fairly, we can compete just about with anybody, anywhere. And exports have been an integral part, at least of the 3rd quarter growth. But far be it for me – I apologize – for not being in the position to answer your question. But I don’t think you want your President opining on whether the Dow Jones is going to – (laughter) – be going up or down.”

      The President’s view is a cardboard cutout of the type of fundamental view shared by the vast majority of market participants. An excerpt from Yahoo! Finance outlining a typical market day is instantly familiar: “It started off decent, but ended up the fourth straight down day for stocks. Early on, the indices were in the green, mostly as a continuation from the bounce Monday afternoon, but as the day wore on and the markets failed to show any upward momentum, the breakdown finally occurred. The impetus this time was attributed to the weakness in the dollar, even though the dollar was down early in the day while stocks were up. Also, oil prices popped higher on wishful thinking statements from a Venezuelan official about OPEC cutting production. Whether or not these factors were simply excuses for selling, or truly perceived as fundamental factors hardly matters.”

      Millions consume news or fake news drivel such as this every minute, hour, day, year, and decade. Thousands have watched the likes of CNBC’s Jim Cramer’s Mad Money show promote similar projections for what seems like decades (actually back to 2005). But predictions based off fundamental analysis are a crapshoot guessing game, as you will never know all fundamentals in what has become an ever-expanding fact and fact-less society.

      But instead of helping people to understand news is not at all critical to their moneymaking decision making, politicians across the globe are gearing up to stamp out the supposed scourge of fake news. For example, State of California Assembly member Jimmy Gomez introduced Assembly Bill (AB) 155 in 2017 “to ensure that upcoming generations of online readers possess the analytical skills needed to spot fake news. The bill would direct the Instructional Quality Commission to develop and adopt curriculum standards and frameworks that incorporate civic online reasoning, for English Language Arts, Mathematics, History, Social Science, and Science.”

      [Insert your own Orwellian reference.]

      Trader Ed Seykota notes across the board cognitive dissonance in play with a simple story: “One evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife off the edge of the table. He watched the knife twirl through the air, as it came to rest with the pointed end sticking into his shoe. ‘Why didn’t you move your foot?’ I exclaimed. ‘I was waiting for it to come back up,’ he replied.”31

      Everyone knows an investor waiting for their market to come back, and it often never does. The financial website Motley Fool has a back-story, a narrative behind its start that reinforces the folly of fundamental analysis: “It all started with chocolate pudding. When they were young, brothers David and Tom Gardner learned about stocks and the business world from their father at the supermarket. Dad, a lawyer and economist, would tell them, ‘See that pudding? We own the company that makes it! Every time someone buys that pudding, it’s good for our company. So go get some more!’ The lesson stuck.”32

      The Motley Fools’ David and Tom Gardner’s pudding story is cute, but it’s misleading in design. Their plan gets you in, but it doesn’t get you out or tell you how much of that pudding stock you should buy. Many low information types believe that easy to digest narrative. I can only scream inside my head: “Houston, we’ve got a freaking problem!”

      A second market theory, technical analysis, operates in stark contrast to the funnymentals. This approach is based on the belief at any given point in time, market prices reflect all known factors affecting supply and demand. Instead of evaluating fundamental factors, technical analysis looks at the market prices themselves. But an understanding of technical analysis can quickly become confusing and controversial. There are essentially two forms of technical analysis. One is based on an ability to read charts or use indicators to predict market direction.

      And predictive technical analysis rightly deserves poignant criticism:

      “I often hear people swear they make money with technical analysis. Do they really? The answer, of course, is that they do. People make money using all sorts of strategies, including some involving tealeaves and sunspots. The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Most academic financial experts believe in some form of the random-walk theory and consider technical analysis almost indistinguishable from a pseudoscience whose predictions are either worthless or, at best, so barely discernibly better than chance as to be unexploitable because of transaction costs.”33

      This is the view of technical analysis held by most who think they know of it – that it is a form of chart reading, astrology, moon cycle analysis, chart pattern wiggle feelings, Elliott waves to the first, second, third, fourth, and fifth degree, and – Barry Ritholtz’s favorite one to skewer – the Death Cross. Big bank equity research departments add to confusion by asking the wrong question: “The question of whether technical analysis works has been a topic of contention for over three decades. Can past prices forecast future performance?”34

      It gets worse. Consider a recent Red Alert example from HSBC: “The Head & Shoulders Top with the neckline acting as resistance comes on top of a potentially bearish Elliot Wave irregular flat pattern and the fact that the index is now backing off from the old 2015 highs. A close below 17,992 would be very bearish. Pressure would ease above 18,449.”35

      Good luck with that.

      There is a second type of technical analysis that neither predicts or forecasts. This type is based on reacting to price action, as trend trader Martin Estlander notes: “We identify market trends, we do not predict them. Our models are kept reactive at all times.”36

      Mebane Faber expands on reaction by noting three criteria are necessary for a model to be simple enough to follow, yet mechanical enough to remove emotion and subjective decision making:

      1. Simple, purely mechanical logic

      2. The same model and parameters for every asset class

      3. Price-based only37

      Instead of trying to predict market direction (an impossible chore), trend following reacts to movements whenever they occur. This enables a focus on the actual price risk, while avoiding becoming emotionally connected with direction, duration, and fundamental expectations.

      This price analysis never allows entry at the exact bottom of a trend or an exit at the exact top. And you won’t necessarily trade every day or week. Instead, trend following waits patiently for the right conditions. There is no forcing an opportunity not there. And with this view there are not exact performance goals. Some want a strategy that dictates, “I must make $400 a day.” The trend following counter is, “Sure, but what if markets don’t move on a given day?” Trend following works because you don’t try to outthink it. You are a trend follower, not a trend predictor.38

      Discretionary versus Systematic

      There are investors and traders, and trading can be fundamentally or technically based. Further, technical trading can either be predictive or reactive. However, there is more distinction. Traders can be discretionary or mechanical.

      Trader John W. Henry makes a clear distinction between the two strategies: “I believe that an investment strategy can only be as successful as the discipline of the manager to adhere to the requirements in the face of market adversity. Unlike discretionary

31

Jack Schwager, Getting Started in Technical Analysis (Hoboken, NJ: John Wiley & Sons, Inc., 1999).

32

“The History of the Motley Fool,” Fool.com, November 4, 2003.

33

John Allen Paulos, A Mathematician Plays the Stock Market (New York: Basic Books, 2003), 47.

34

“Quantitative Strategy: Does Technical Analysis Work?” Equity Research, Credit Suisse First Boston (September 25, 2002).

35

Bob Bryan, “RED ALERT – Get Ready for a ‘Severe Fall’ in the Stock Market, HSBC says,” Business Insider, October 12, 2016, www.businessinsider.com/hsbc-red-alert-get-ready-for-a-severe-fall-in-the-stock-market-2016-10.

36

Martin Estlander, “Presentation for the Association of Provident Fund of Thailand & Partners” (Association of Provident Fund of Thailand & Partners, Bangkok, February 26, 2015).

37

Mebane Faber, “A Quantitative Approach to Tactical Asset Allocation,” The Journal of Wealth Management (Spring 2007).

38

Daniel P. Collins, “Kevin Bruce: Improving on a Passion,” Futures (October 2003).