A review of the updated edition of ‘Trend Following’ by Felix Sim.

Sure seems like trend followers!

Nice quick reminder this morning.

From Yahoo Finance today:

Wall Street has recovered earlier losses on investor worry over the possibility of a major swine flu outbreak. Investors were nervous that the flu could spread and thwart economic recovery; in later trade, they are scooping up shares of drug makers and pharmacies.

Everyone realizes that piece of “reporting” was entirely made up, right?

I admit to laughing out loud to some parts of that piece. Great stuff. I love how kids are being trained to not take a loss.

I caught some comments today that provide useful instruction – for all the wrong ways to think about trend following. While the author may indeed be intelligent, when it comes to trend following, he has no clue. His first comment:

Before you can follow a trend, you must be able to determine that a trend exists and that it is actually in progress at the present moment. Is it possible to make this determination with any certainty?

Actually you can’t know that a trend exists upon entry. You can’t know a trend until it is over. More from the same writer:

Let’s say you look back and see that a trend has occurred in the past. How can you determine the causal factors that brought about the trend in the first place? If you could determine the factors that precipitated the trend, how can you be assured that the same factors occurring in the future in a different market would generate the same buying and selling responses that created the prior trend?

What do the factors that cause a trend have to do with making money as a technical trend follower? Trend followers do not concern themselves with the factors that cause trends. More from the same writer:

My take is that seeking trends in the market and talking about trend following is a form of a faith-based activity.

Let me get this straight: The $10 billion or so invested with Winton Capital was done because those investors believe Winton is practicing some form of unscientific religion? I can’t figure out if these comments are truly ignorance or some form of misinformation. Either way I remain energized to get as many investors as possible to at least become aware of trend following. Once most investors have actually heard of trend following my job will be complete, but I clearly have a long way to go.

From Barry Ritholtz – the sobering view.

From Barrons:

Leading us to the question with which we began these musings: If those now infamous shoots of recovery are popping up all over, why would insiders be so aggressively dumping stocks?

Yet, they indisputably are. According to a study prepared for Bloomberg by Washington Service, a research outfit, directors, officers and the like have sold $353 million worth of stock in this fading month, or 8.3 times the total bought. As a matter of fact, according to the firm, insider purchases of $42.5 million are on track to make April the skimpiest month for such buying since July 1992.

The pace of selling in the first three weeks of this month, incidentally, was the swiftest since the market peaked and the bear came out of hibernation with a vengeance in October ’07.

We’re quite aware that insiders are not infallible. But they are, after all, in the front lines of commerce and industry and so presumably have a better fix on the economy and the prospects for recovery than analysts and economists, whether of macro or micro persuasion.

And just as they wouldn’t be laying off people in such extraordinary numbers if they thought their business was about to rebound soon, they’d be loath to liquidate their holdings in such an emphatic way if they espied a turnaround in the offing.

It all boils down to this: Nobody ever sold a stock because they thought it would go up. And as a group, corporate insiders obviously are scarcely enthusiastic about the prospects for a genuine bull market.

If the people on the inside are dumping…the guillotine has dropped.

This review caught my attention:

This review is unlikely to make me friends, and likely to generate some negative mail. Let me start with the conclusion: don’t buy the book. That said, my reasons for stating this are different from those who typically criticize Michael Covel. I agree with much of what he says; I disagree with much of his rhetoric. Let me give you my thoughts:

1) Momentum is a pervasive factor in the markets. It works about 80% of the time and produces significant excess returns on average. Behavioral finance points out that people are slow to adapt to new information, so momentum tends to work because the initial moves on new information aren’t sufficient. That said, when too many are chasing momentum, the market becomes extremely volatile, and the strategy ceases to work, until it shakes out enough momentum-followers.

What is hard, is distinguishing trend following from technical analysis from momentum. Personally, I think momentum explains the other two. It’s a much simpler theory, and much as Covel appeals to Occam’s Razor, I apply it back to him here.

2) He draws on a series of investors that have done well in the past, and touts them as proof of his theories. Hindsight is 20/20. What of those that have tried to apply trend following and failed? Is it many or few?  Keeping a tight stop loss for some means the death of a thousand cuts. The studies that I have seen show that frequency of trading tends to decrease returns.  Now, trend following does not necessarily mean a lot of trading, but for many it ends up being that way.

It is easy to locate a bunch of trend followers in hindsight, and tout their abilities. What would be harder would be to find the whole universe of people following trends, and see how they do as a whole.

3) Mean reversion is a weaker factor, but still significant in making money. Value investors typically do well with it, but only reliably when they insist on strong balance sheets. I’ve studied mean reversion for years, and it exists in almost all markets as a weak factor. Over enough time, that weak factor has punch, but in the short run, momentum rules on average.

4) Covel spends a lot of time trashing fundamental analysis, without much meat behind it. Fundamental analysis works well, but doesn’t have so much value because so many are applying it. It’s not like the situation Ben Graham found, where few were doing it.

Aside from that, technicians implicitly rely on fundamental analysis, because their support and resistance levels stem from the decisions of fundamental investors. Same for those that follow trends. The trends exist because fundamental investors react slowly to changes in the fundamentals, and trend followers exploit them.

5) There is no mention of the Adaptive Markets Hypothesis, and little discussion of Behavioral Finance. These are much richer theories that encompass ‘trend following.’

6) Covel takes ‘pot shots’ at Buffett over issues that are unrelated to his main point in an effort to discredit him. Buffett is a bright guy who can criticize derivatives in aggregate, while still using them in specific to his advantage. (Cough, cough.  Please ignore his put option trades.)

7) There was not enough time spent on ‘how to trend follow.’  After reading the book, if I didn’t have prior background knowledge, I would be scratching my head to figure out how I could reliably pick investments in a trend following mode in order to make significant excess profits, as well as know where to sell them.

I don’t recommend it, but you can buy it here: Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets.

Final note – Covel needs to grow up and learn that there are other factors in the market aside from momentum.  He has become a fundamentalist about ‘trend following’ and does not seem to have the open mind that he harps about.

PS – Remember, I don’t have a tip jar, but I do do book reviews.  If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra. Such a deal if you wanted to get it anyway.

Who is Merkel:

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

A Cramer trainee.

These folks regularly block roads in San Diego (like tonight). I am sorry, but the means they use are worthless. I liked John Lennon, but his political rebellion (“sleep-ins”) was also worthless.