Michael Covel: News & Info.

Great feedback from a reader on “simplicity”:

“I found your interview dated November 7, 2005 interesting and enjoyed it very much…I personally know quite a few trend followers that adhere to the idea that systems drift over time and need to be tweaked. Such traders sow the seeds of their demise. They lack the tendency to idealize, and instead pay attention to small features and choose to ignore clarity and simplicity. Their ideas (not methods) are not scientific. Such traders lack the ability to translate their ideas into firm trading rules. They add complexity and noise when they should be doing the exact opposite. Science is about principles and principles that can be dated are not principles. The supreme task of a trader is to arrive at a broad principle that addresses the trading process - the profit generating mechanism. And such a ‘principle’ can be assimilated, validated, corroborated and verified. From this principle, a system that will not be dated can be built by pure deduction. Many have difficulty understanding how one can make money through a disciplined use of a simple volatility based money management system. They are conditioned to think in linear terms where cause and effect are clearly linked. They don’t realize the simpler the theory the less it will look anything like the world they see. The key to really understanding the profit generating process is not system optimization, endless estimation, and blind number crunching. While facts reside in the real world, principles reside in the mind. These traders attempt to start by looking at the data and try to ‘warm the general principle out of the system.’ And as the data drifts over time, the supposed principle gets dated. To find principles that stand the test of time requires a leap into the unknown, into the darkness of our mind and feelings where imagination and intuition hide. It is cognition resting on sympathetic emotions which hopefully lead to the first principle. Only then do we test the validity of the evidence by observing how well it fits the theory - the first principle…P.S. Kudos is due you for your brilliant work on trend following.”

I found this one of the best emails I have ever received. To the point and on the money.

This chart supplied by a reader is pure Holy Grail. It is emblematic of the types of “feel good” stories people will push to “explain” market movement. Steer clear.

Take a look at the sugar trend for the last year:

View Chart

Sugar is one of those markets that can rocket on a whim. Veteran traders will easily recall the years when markets like Sugar or Coffee or Cocoa traded substantially higher or lower - the big trends out of nowhere. Often sparked by an assortment of third world concerns, these markets have a tendency to produce large trends in a short period of time.

Look at sugar now. It has exploded to recent highs, highs not seen in more than a decade. But how could you have taken advantage of a move like this? How could you have been ready for the next world event to shoot sugar to the moon? You need to trade with rules. You need to have a system. You need to be ready, with a market like sugar on your watch list, ready to enter on breakouts as it is making new highs or lows. You have no idea when you enter if it will go to the moon, but you still need to have a method that will get you “in” to be on board so if it does rocket up - you don’t miss it.

This Sugar move is even more proof of the theorem that trend following exploits “worldwide events”. Trend followers had ample time to position in Sugar while it was trading around 8.00 - long before the market blew through 12, 14 or even 18. What technical signal would not have had you squarely into the Sugar trend?

Trend following entry into the Sugar happened long before Brazil began to emphasize more and more sugar to make more Ethanol. Or you could possibly argue that the fundamental reason for Sugar’s rally is tied to Crude Oil. However, the fundamentals didn’t matter if you were trading to take advantage of this incredible move. Sugar began moving higher long before the public knew about Brazil’s re-emphasized energy policy. Traders who waited on the fundamentals to “explain” the rationale for the Sugar trade missed the initial breakout, and the big profits that resulted.

Why do people have such a hard time just accepting the sugar trend (or any other trend) and just riding it? Why do people feel the need to explain “why” the move happened?

Feedback today that sums “it” up nicely:

“I believe that most people prefer to think that a ‘business approach to investing’ just makes sense - plain and simple. Though if you bring the discussion further, and really delve into what that means, and specifically, how it’s reliant upon prediction, then you get a lot of blank stares. People have told me that they might not know the ins and outs of how their money manager is making decisions, but they know he is using ’sound investment principals’ and they feel safe with that. When I bring up price being the real-time determinant of value, when I bring up money management and systematic trading decisions, as a clear way to be actively involved in your chance of turning your nest egg into an eagle, I get a lot of negative responses. The feedback I get is that people want to think that you need to be a hard working detective to really dissect these companies, understand the businesses, know the management, read the economy and then make an investment based on these ‘facts’. They really would rather have that, and pay for that, and buy into that - then work on themselves and take responsibility. I certainly don’t think everyone is that way, but it seems that the majority is.”

This post from yesterday brought this feedback:

“The problem with [these] statements [is] that [they] totally downplay the use of ‘technical charting’ as a means of trading. My question…would be, if you believe in [a] Trend Following methodology, how do you answer the five questions in Chapter 10 [of Covel's book] without looking at a chart or at least at a table of numbers? Do you peruse astrology tables or consult a Ouija board? No, of course not. You look at a chart just the same as does someone who does ‘technical analysis.’ What if a true novice who is trying to learn about [trend following] were to read [these] statements as his or her first exposure to the concept? They might easily deduce that they should never consult a chart. Charting is not the enemy. Stochastics, RSI’s, moving averages, et al are the components of ‘technical analysis’ that are the culprits. But, let us not confuse charting with technical analysis.”

I don’t know what a true novice or anyone for that matter would do with a “chart” exactly. Trend followers use price data to make decisions. They look at the raw numbers for their signals and bet sizing. They don’t “read charts”, whatever that means exactly.

In terms of “technical analysis”, I have tried to make clear the case in my book that there are two popular ways to view the subject. One involves prediction (useless) and one involves reaction (employed by the great traders). I cringe when I hear the term “technical analysis” as the term has no universal defintion and means so many things to so many different people.

Perhaps the feedback above about yesterday’s post and my comments in retort will provide clarification to a subject area riddled with never-ending jargon.

Ken Huck of Edge Ware, Inc. produces software for trend following. He wrote me the other day with an excerpt from John Mauldin’s writings quoting Dr. Gary Hirst of Hirst Investments:

“I had heard about technical analysis and chart patterns and, looking at this stuff I would say, what kind of voodoo is this? I was very, very skeptical that technical analysis had value. So I used the computers to check it out and what I learned was that there was, in fact, no useful reality there. Statistically and mathematically all these tools - stochastics, RSI chart patterns, Elliot Wave, and so on-just don’t work. If you code any of these rigorously into a computer and test them they produce no statistical basis for making money; they’re just wishful thinking. But I did find one thing that worked. In fact almost all technical analysis can be reduced to this one thing, though most people don’t realize it: the distributions of returns are not normal; they are skewed and have “fat tails.” In other words, markets do produce profitable trends. Sure I found things that work over the short term, systems that work for five or ten years, but then fail miserably. Everything you made, you gave back. Over the long term, trends are where the money is.”

Here is an interview (MP3) I did recently with Ed Foster of the Making Money with Doug Fabian radio show. The interview is nearly 70 minutes long.

Barry Ritholtz of The Big Picture writes today at his site:

“I have to emphasize again: I don’t believe in forecasting. I don’t know what’s going to happen next year; Neither do you, nor does anyone else, for that matter. Bull or Bear are irrelevant labels.”

Nice sum up on a volatile market day. And he is not being sound-bitish, just real.

From Morningstar.com today:

“What makes Greenblatt’s [book: The Little Book that Beats the Market] message valuable is its focus on investing as opposed to speculating. Investing involves risk, but it is not buying something with the hope that you’ll be able to sell it to someone else for a greater price later. Investing is financing the operations of a business, and it involves trying to understand if that business is healthy enough and profitable enough to give you an adequate return on your capital from its operations, based on the price you’ve paid for your interest in those operations. This is what Warren Buffett has called a “business” approach to investing, and it’s the one we favor at Morningstar both when we analyze stocks and when we evaluate the investment processes of mutual fund managers. Our stock analysts prefer free cash flow yield instead of earnings, as they believe free cash flow is a more accurate measure of the amount of cash that can be lifted out of a business without disturbing its operations. They also use something called a discounted cash flow analysis to value the stocks they cover, but the principles are the same as Greenblatt’s.”

Is it easier for the average person to wrap their arms around the idea of “financing the operations of a business” or simply trading based on daily price action? Is it more realistic for the average person to be an “investor” or “trader”? Thoughts on the subject? Email me.

From the Post:

“Let’s start with the good news: You are about to win $500. No, it’s not 100 percent certain, but frankly, it looks pretty darn good. All you need to do is drive to New York, buy a lottery ticket and play the number 686. Hello 500 smackeroos! It’s basically a lock and you want to know why? Well, Roy Siano is glad you asked. “Double sixes are our best bet for the next issue,” he says. That would be the next issue of 3 + 4 Digit Lotto Stats, one of two biweekly publications owned, edited and published by Siano and his business partner for the past five years, Stephen Allensworth. Each issue of Lotto Stats and its sister magazine, Lotto News, purport to do what any mathematician will tell you cannot be done: teach you how to win the lottery. For $2.95 per issue, you get 32 black-and-white pages stuffed with reams of data, dozens of charts and erudite-sounding advice from a handful of columnists, each offering strategies to gamble your way to Fat City courtesy of the New York lottery. Plenty of these columns come off as — what’s the polite phrase here? — utterly cockamamie. One is based on astrology, another on interpreting dreams. Readers in a recent issue who saw a door in their REM sleep, for instance, were advised to play 271. Why? Unclear. But that’s the more fanciful stuff. Siano and Allensworth claim that solid logic undergirds the “hit frequency charts” and “pattern tables” crammed into their magazines. It boils down to this: If you flip a coin nine times and it keeps coming up heads, what should you bet will happen in the next flip? “Tails, of course,” says Siano, who at the moment is sitting at the dining room table in Allensworth’s apartment in Port Chester, a suburb of New York near the Connecticut border. “We use gambler’s math,” says Allensworth, who is sitting on the other side of the table. “What it does is track events. Sometimes numbers are out for a long time,” which is to say, they fail to show up in winning combinations. “Generally speaking, after they’ve been out for a while, they tend to make up lost ground.”

Huh?