From “How Wall Street Learns to Look the Other Way”, New York Time Op-Ed, Tuesday, February 8, 2005:

“Whatever happens with Mr. Grasso – and with Dennis Kozlowski of Tyco and the other avatars of corporate misconduct in the headlines these days – we should be reminded that ethical behavior for many business people must involve overcoming their learned biases. Perhaps these scandals would be a little less likely, and the rationalizations for them a little less tenable, if more of us professors integrated business education into a broader historical and psychological context. Would our students really fail to understand the economic models if we treated the subject matter not as an arcane specialty, but as part of a larger liberal arts education?”
Robert J. Shiller

Shiller may be a brilliant writer, he authored Irrational Exuberance, as well as professor, he teaches Financial Markets at Yale College, but he’s dreaming if he believes those on Wall Street behave unethically because of what they didn’t learn in business school. Learning to take responsibility for your actions, just like learning to trade properly, has little to do with a graduate degree in business or any other field.

From The Financial Times on February 9, 2005:

“Investors who buy shares in companies in fast growing economies are risking disappointment because there is no clear link between equity returns and GDP growth.”
The Financial Times

More importantly there is no clear link between the fundamentals (however those may be sujectively determined) and the price of the stock, currency, future, etc. You can have the greatest fundamentals in the world and still see a stock tank. Of course, and we should all know this now post bubble, the fundamentals can be terrible and a stock can soar.

One of the goals of Trend Following was to better explain terms like “risk” and “risky” (see p. 89-95). Saying something is “risky” tells you nothing. To those who don’t understand trend following (or for those who refuse to admit the strategy’s success) the easy way to feel good about ignorance is to quickly say, “trend following is risky.”

We have to risk to find opportunity of gain. If you don’t risk, there is no possibility for gain. Risk is not a four-letter word. A good example? Trend followers do not make money each month with their “risks”. They never have. They don’t expect a gain every month. Trend followers see just as many losing months as winning months. That scares you? It should not. At least trend followers understand and acknowledge there will be down months when taking calculated risk. On the other hand, those who promise positive returns every month are the cons.

View trend following performance for January 2005. It was a down month across the board for most trend followers. I hope, “Oh my trend following lost money for a month it must not work!”, was not your reaction. Don’t look at one month in isolation and attempt a judgment — you would be foolish. Look at the decades of trend following performance (month by month) across numerous trend following trading professionals — there is your real insight.

The phrase “buy low and sell high” is so pervasive in our culture that few stop to consider the implications of believing it. It just sounds so good, who could argue with the logic. Right? Wrong. How do you consistently determine what is “low” or what is “high”? What does “low” or “high” mean in practical terms? “Low” or “high” relative to what?

Recent feedback from a top Wall Street Technical Strategist:

“I started and finished your book on the stunning Beaches of Ipanema, Brazil. I have to tell you that I thought it was fascinating, insightful and extremely readable. The format made it very easy to soak up all the information, which I feel is the most important aspect of a any book period. Above all else however, I came away with a much better understanding of my trading paradigm now that I can validate and categorize – giving me a label if you will – my trading style. Reading your work also afforded me a great feeling of comradery and renewed confidence in my understanding of the markets. In fact, I had never know that I was a ‘Trend Follower’.”

Interestingly, many traders who you never would have expected to find a common bond with Trend Following, have written to express similar sentiment.

From Barrons this weekend:

“Everyone, even the little old lady in Peoria, knows about the Super Bowl indicator and its uncanny ability to predict the stock market. But for the benefit of the tourist from Mars who’s just passing through and hasn’t had time to bone up on such exotica, we’ll whistle up a brief exegesis. The National Football League is divided into two parts: the National Football Conference (NFC) and the American Football Conference (AFC). The survivors in each conference of an interminable stretch of playoffs meet in the fabled Super Bowl. Got that so far? (We’re talking to you, the funny-looking green guy with the antenna coming out of the sides of his head.) Okay. If the NFC team wins, the stock market is destined to go up that year. If the AFC team wins, the stock market’s a goner. This indicator has been right 30 out of 38 years, which betters by far the record of any Wall Street strategist or even someone who knows something about the market. We’re deeply indebted to the excellent Richard Bernstein of Merrill Lynch for the revelation that there’s another, little known Super Bowl-stock market indicator (Richard, in turn, says he’s indebted to National Public Radio for the info) that turns on animal versus human mascots. There have been 25 Super Bowls in which teams with human mascots have contested against teams with animal mascots and, we’re pleased to say, the humans have emerged victorious in 18 of those games. (If a team ever called itself the “Traders,” as in brokerage house traders, we’d be at a loss to say which category it fell into.) Richard, obviously a mathematician, used both indicators to gauge the prospects for the stock market this year. The teams vying for supremacy are the New England Patriots, the AFC champs, and their NFC opponents, the Philadelphia Eagles. He figures that based on the human/animal rule, there’s a 72% chance the Patriots beat the Eagles. If that happens there’s a 79% chance, according to the original Super Bowl indicator, that the stock market declines in 2005. Combining both indicators in some mysterious fashion which he does not disclose, Richard divines a 57% chance that the market will wind up the year lower. While we’re at it, we might as well toss in the January indicator, which holds that as goes January, so goes the year as a whole for the stock market. There has been a lot of ink spilled on why that ain’t necessarily so. But a very savvy friend of ours points out that in each of the past 13 post-election years, January has, indeed, been a forerunner of the stock market’s action, up and down. In case you’ve forgotten, January 2005 was a downer.”

These articles are fun, but they serve little purpose. Remember the Washington Redskins indicator for the U.S. Presidential election?

http://www. snopes.com/politics/ballot/redskins.asp

“Our desire to understand and assert some control over the world around us is often manifested by our attempts to find predictive signs that enable us to prognosticate events–even Vote when there is no seeming connection between predictor and event. Sometimes one natural phenomenon supposedly forecasts another, as in the belief that a groundhog’s seeing his shadow on February 2 portends another six weeks of winter. In other instances the linkage is between affairs of mankind, as in the superstition that the winner of football’s Super Bowl augurs that year’s stock market performance (or vice-versa).” Snopes.com

Recent feedback:

“I have been a “lurker” [at the web sites] for some time now. I seem to recall someone writing in one time to defend fundamental analysis as the only way to invest. The answer was that fundamental analysis might tell you when to buy but didn’t tell you how much to buy or when to sell. Somehow, that answer didn’t seem to satisfy me, but I couldn’t put my finger on the reason why. You see, I am a fundamental analyst and portfolio manager. I put myself squarely in the Graham and Dodd camp, along with other such luminaries as Sequoia Fund, Warren Buffett, Longleaf Partners and Tweedy Brown. I just purchased the Michael Covel book Trend Following and have started reading it with much interest. As I was plowing through the first chapter, it began to occur to me that I am a closet trend follower, as are many of my value oriented colleagues. How did I arrive at that conclusion? Let’s go back to the answer that was given about fundamental analysis. That answer would certainly dispel any myths about trend following being better than fundamental analysis if it were truly the case that one ran the numbers, bought a stock and forgot about it. Trouble is, it doesn’t work like that. You get new information about your purchase at least every quarter. At that point, any money manager worth his salt is re-evaluating his holdings in light of this new information. Sometimes you revalue your holdings upwards, other times, downwards. Some change very little. Next look at current price versus the newly calculated valuation. If the risk/reward ratio is sufficient, buy more. If it’s not, hold what you have. If the valuation has gone down enough or the price risen sufficiently, you sell. It is interesting to note that, currently, most of the Graham and Dodd investors are holding a significant portion of their assets in cash (myself included). This is because there is nothing that meets our value criteria to buy and, of the holdings that we held, they have become overvalued enough to take profits on. So trend following and fundamental analysis are not mutually exclusive as some of you might think. If things are done properly, good fundamental analysts will follow a trend. As for your argument on position sizing (‘fundamental analysis won’t tell you how much to buy’), you are correct in that statement. But trend following won’t tell you that either. Position sizing is a personal choice and is a necessary part of ANY competent investment program. The decision to add to positions that offer better rewards and sell out of positions with declining or negative rewards is critical. I look forward to finishing Mr. Covel’s book. I am still intrigued by trend following techniques. I do not argue with the successes of those who follow the techniques. I think the polarizing element is the perception that the only way to trend follow is to use technical analysis and technical analysis seems like so much hocus-pocus to so many folks (more often than not, with good reason).”
Alan M., CFA

Nassim Taleb was asked about common mistakes traders make. He responded to Derivatives Strategy with an answer useful for both beginner & expert:

“As a trader, my job is to understand biases and trade on them. There are all kinds of biases. The most common is the small sample bias. Let’s say you have 1 to 1000 odds you will come home every day with a dollar and once in a while you lose $1000. Many traders show very steady incomes but they could be fooling themselves because they don’t have a long enough period of time to chart their performance. Their Sharpe ratio will not be indicative. In option trading, there is a similar bias. Short premium option traders, typically those who sell out-of-the-money options, are more likely to make money on a daily basis and then blow up. Likewise the yield hogs, those traders who would take any risk for a few basis points. You can fool yourself with your Sharpe ratios, and you can fool all of the financial engineers, but you can’t fool an old Chicago trader who went bankrupt twice.”

The other day a reader asked me if trend following would beat his current strategy. He said he consistently makes +25% a month every month. Taleb’s comments are useful for this individual.

In the January 25, 2005 issue of the Australasian Investment Review the following “insight” was presented:

“All things being equal, a stronger US$ should result in lower commodity prices, while a weaker US$ will have the opposite effect. This is because a stronger currency reduces production costs in non-dollar linked currencies and raises prices in other currencies, which can deter buying…At some point, supply and demand balances take over and the commodity price will fluctuate irrespective of exchange rates. Nickel is a prime example of this, Macquarie argues, as the nickel price continues to ‘enjoy’ wild swings in prices regardless of the level of the US$. For example, the broker points out much of nickel’s recovery in June-July last year was while the US$ was rising, and as other commodities were trading more in line with the weaker Euro. It is the broker’s view that zinc is beginning to show signs of following the example of nickel, as in recent weeks the price of the metal has held up despite a stronger currency. The moral of the story? The trend is your friend, but don’t forget about the fundamentals.”

At the very end we are told the trend is our friend. I agree. But then we are told to not forget about the fundamentals. I assume the author is proposing to use both? How does one do this? Is there any track record of any professional trader for some minimum of time that combines trend following and fundamental analysis? Don’t these 2 disciplines conflict with each other on a base level?

Trend Following will be translated into Russian. Release is set for 2006.