Michael Covel is the author of the internationally bestselling book Trend Following

$1 Contest

May 31, 2006

I have decided to run a contest. I will pay $1 to whoever can provide the best fundamental explanation or "story" for the movement of this chart.

Practice Makes

Brett Steenbarger authored this article on practice (PDF). It is a real good piece, except of course trend followers who would not be saying:

"...and their ability to read patterns in noisy market data and act upon them has become lightning quick."

That line is my small quibble! That skill is not needed in trend following.

Dear Graduates: Money Is a Means

May 29, 2006

The recent NY Times article "Dear Graduates: Money Is a Means" by Daniel Akst is good reading for all those still denying the importance of money in life.

Continue reading Dear Graduates: Money Is a Means »

Enron's Legacy

May 28, 2006

A good piece of reading (PDF) on Enron's legacy...it's not what you think. An excerpt:

"It has been forgotten, because of the unfortunate things that happened at the top, that Enron had a good group of people who were very innovative," said Robert Shiller, an economics professor at Yale University whose 2000 book "Irrational Exuberance" predicted the stock market crash."

White Paper Research

May 27, 2006

An assortment of interesting research to cross my desk recently:

1. The Rules of the Long-Term Game (PDF)

2. Are Hedge Funds Suitable for Individual Investors? (PDF)

3. Risk Management: From Gut to Quant (PDF)

4. Managed Futures and Varying Correlations (PDF)

Position Sizing Feedback

May 26, 2006

Feedback from a reader:

"While the idea of sizing one's position according to anticipated volatility and available capital sounds reasonable on the surface, recently it appears that all markets in all countries are well correlated. Thus in the current environment position sizing doesn't manage risk very much. For example, if all your appreciating positions decline as simultaneously and deeply as they appreciated, what's the use trying to allocate risk with a 1% thimble? Look at metals for example. Why bother diversifying among the commodities and producers with position sizing? The same result would have been obtained by simply exclusively buying any one of gold, copper, or zinc alone. Diversity among exploration companies and types of metals with [trend] trading position sizes just makes a messy portfolio. In the end they all sold off more or less at the same time and by roughly as they appreciated compared to 100%. Let me explain a bit more about "compared to 100%". I am talking about all available investments being well correlated in the sense of trend following. In Trend Following as I understand it, one seeks the 100% or greater return on investment in a few trades rather than trying to make small gains over many risky capital intensive trades. Furthermore, if you look at every stock exchange in any country that nearly any stock that went up also went down by a comparable amount relative to 100%. If you look at forex, it is ALL US dollar. Dollar goes up a bit, dollar goes down a bit."

Selecting a portfolio to track and trade is not just guessing. Correlation must be considered and even then it is not a perfect diversity measurement 100% of the time. Sometimes, in the short-term, everything can quickly move together.

This reader continued:

"You need huge leverage to get a trend out of the US dollar chop. That's not really trend following is it?

Trend following trading does not attempt to use vast leverage to make money in choppy markets. Period. Trend following loses money in choppy markets.

This reader continued:

"Is this the end of speculative trend following? If it's not dead, maybe position sizing isn't so important in the modern era of investing?"

How can the question of "how much?" ever go out of style? I am not following the logic.

Feedback from New Trading Manager

May 25, 2006

"In response to some of the guru comments you posted in your newsletter last night, I have inserted a quote from “Reminscences …” … “The big men of The Street are as prone to be wishful thinkers as the politicians or the plain suckers. I myself can’t work that way. In a speculator such an attitude is fatal. Perhaps a manufacturer of securities or a promoter of new enterprises can afford to indulge in HOPE-JAGS”. I am a student of your trend following course and an avid reader of your newsletter. I’m currently going through the CTA registration process with the NFA. As I put the finishing touches on my Disclosure Document I am both puzzled and relieved by a comment on the NFA website (all in all I believe the NFA has done a great job guiding a start-up through the registration process), the comment states that when coming up with a trading methodology, to be original, “the world doesn’t need another trend follower”. Puzzled by why they thought it necessary to rebuke a solid trading methodology and relieved that there will always be someone on the other side of my trades. Whether it’s very short intraday trends, betting on spreads getting tighter or wider, medium or long term trends, trading pairs, even value guys have to have trends to make money, my point is call it what you want, the entry is hardly relevant as long as you have a program that’s consistent and gets you involved – what sets the successful apart from the rest is risk management, as you say over and over, “how much?”. Get involved on any signal you want, breakout, moving average crossover, fundamental valuation if you must, but for God’s sake, know your downside and set your stops, cut your losers let winners run, have a strict system for position sizing and don’t get married to your ideas of what the market is going to do in the future, that as Ed Seykota is fond of saying, simply doesn’t exist anywhere, but your head. As I am having meetings with former colleagues to begin raising capital, I am befuddled by some really bright guys sticking to their guns, that it’s not necessary to play around with futures trading and trend following systems, we buy companies now because we know that 5 or 10 or 15 years from now those companies, that make up the bright and shining S&P500, will be higher – they just will be, they always have in the past. HOPE-JAGS! Trade as a trend follower, sleep at night, end of story. Thanks for a great newsletter..."

CTA Portfolio Composition

An interesting piece of research on assembling CTA portfolios from AIMA (PDF).

Warren Buffett on Copper

May 24, 2006

Buffett recently warned:

"You are looking at a market that is responding more to speculative forces than fundamental forces."
Warren Buffett

If he is right, does it matter one way or the other?

How Do You Apply These Comments?

I came across a market newsletter that aggregated various comments from investing newsletters. How do you actually apply the following four comments?

"It's increasingly clear that the primary characteristic of the current marketplace is that there is too much money around, looking for places to put it, perhaps to work, but more evidently to play with. It is reminiscent of one of Fraser's useful buttons: 'Money to burn will find a home.'...In sum, this is not a market climate suitable for initiating long-term investment positions, nor is it suitable for speculation...nor for brilliant market timing. Such slow and teasing deterioration requires patience. Better to be a wallflower than a gambler."
Justin Mamis
The Mamis Letter
April 3, 2006

"In an environment of global event risk, potential fixed income market turmoil, and deteriorating industry group performance, our advice remains to be defensive."
Michael Belkin
The Belkin Report
April 3, 2006

"I believe The Market will continue to groan forward this month, possibly even challenging the old highs. But I don't think the underlying fundamental, technical, economic, and sentiment factors are in place to sustain it. For that reason, we need to begin the process of rebalancing our portfolios. ...I see a flat-to-declining U.S. market ahead. We'll begin to sell our U.S. market-sensitive issues - even some of those that I still believe in long-term. My plan is to move you more completely into metals, timber, and energy, all of which will move contra to the market in general, as well as to seek some special situations in foreign markets to which the U.S. market correlates poorly."
Joseph L. Shaefer
April 2006

"The greenback now looks vulnerable to a breach of 88.00, which would increase the risk profile toward 86.00 and negate the potential for the U.S. dollar to fulfill the previously anticipated upside."
Ron Daino
The Day of Reckoning is NOW for the U.S. Dollar ... And It's Failing!
April 5, 2006

I am not questioning the intelligence of these men. There is a side of me that always like a good market story, but I just don't see how these kinds of statements can be applied to 'when to buy', 'when to sell' or 'how much to buy or sell'.

Note: Joseph L. Shafer, quoted above, responded to this blog post with the following:

Clearly you are unwilling to issue a retraction or explanation for your out-of-context quote no matter how compelling the evidence. We won't communicate further. I answered your question 3 different ways. I read the article you sent me from 2000 -- it sounded suspiciously like what I wrote in my first book 20 years ago. Bottom line: We tell subscribers how many shares of what stocks to buy at what price, when to sell, and at what price. We know it, our peers in the business know it, and our subscribers and clients are wealthier for it. You'll note on page 10 of Investor's Edge (R) the words "All rights reserved" and "Copyright." Do not violate our copyright by quoting us without permission. Bloggers may wish to spread their words indiscriminately but, as professionals in the business, we take infringement of our trademarks &/or copyrighted material very seriously. If you respond, which I do not expect, respond to our Legal Department at charperesq@investorsedge.us. Good day, Joseph L. Shaefer, Chairman The Stanford Advisory Group

Promises

May 23, 2006

Ed Seykota was recently asked at his site:

"When you select what looks like a "promising" stock, do you keep pulling the trigger after being stopped out or do you move on to other markets if the first attempt fails? The reason I am asking is because I noticed many stocks will breakout with strength only to fall back, hit my stop, linger a couple months or so and then really take off."

Ed responded:

"A promise is a statement that you will do something in the (non-existing) future. As such, all promises have an inherent design flaw. I don't know of any stocks that make promises. I merely know stocks that meet various mathematical criteria in the now. You might consider having a look at what you mean by a "promising" stock."

Larry Williams and Tax Problems

Trading guru Larry Williams better get what appears to be tax problems fixed with the IRS! Read.

-57% Drawdown Still...

May 22, 2006

Six years after the Spring 2000 Nasdaq crash, from a buy and hold perspective, the index is still in a -57% drawdown. That's a long time for all of us generations who were constantly told to sit back and just trust buy and hold. Then again, as I have said often, the Japanese surely don't believe in buy and hold. Their stock index, the Nikkei 225, is still in the middle of a -60% drawdown spanning over 16 years. That's tough sledding for buy and holders.

The Future of Futures

May 21, 2006

Leo Melamed offers this perspective on the future of futures (PDF). An excerpt:

"Clearly there will be new financial scandals. Long Term Capital Management, Enron, WorldCom, Allied Irish Banks taught lessons that greed will quickly erase. While those scandals caused some hand wringing and finger pointing at derivatives markets, by and large they did not impede their growth. Indeed, one can make the case that while such scandals result in intensified scrutiny by regulators, they often serve to increase rather than decrease the use of risk management applications provided by our markets. Above all, such scandals often underscore the need for transparency that is best provided by organ- ized futures exchanges."

Article on "Risk"

May 20, 2006

A recent article of mine covering "risk" basics (PDF).

Theresa Lo Comment on Price

May 18, 2006

Theresa Lo offered a nice comment on price:

"I know you’re used to reading financial blogs that opine ad nauseum everyday. I have no idea how they do it, nor am I going to try. You see, I show up each morning to make money; cash facilitates life. I don’t care for conspiracy theories or consider fiat currency an Ayn Rand moral dilemma. I won’t waste time tracking the defunct M3. Who cares if the Plunge Protection Team is real or not? @*$%@#$ corporate greed. I cannot right the alleged wrongs of capitalism - that’s what the SELL button is for. Use it. I simply accept the Darwinian nature of the markets. There is a financial circle of life and it cannot be defied. There is no good or bad. There are only profits or losses. That’s why tracking and trading price is the way to go. In an imperfect world, it’s all we have."

Nasdaq Drop

The Nasdaq has been dropping. I have no idea why, nor do I believe anyone else really has an idea why it has dropped. Consider the chart:

Nasdaq

Imagine all you have is that.

Even if you had all of the "news", "opinions" and "analysis" from the last 6 months, how would it help you to trade that chart? Many trend following programs, if in the Nasdaq, are most likely short now. Does that mean they are right about direction? No, it just means that a directional shift has happened. When just staring at the chart, don't you feel more secure using daily price data for decision-making v. "news" and "opinions"?

A Nice Run, But...

May 17, 2006

Recent feedback:

"Please relay to Michael my thanks. I've spent the last two and half years trading commodities and trashing back and forth between success and failure. After applying trending following principals from his book, my portfolio and I feel like we have direction. No more thrashing. Granted I've been in a hot copper, gold, and silver market but the fact that I was in it and not trading IN and OUT can be traced to Michael. I've taken my $60,000 to $330,000 in 2 months, and I'm no longer stressing over market moves like I did during my "TRASHING PHASE". Please thank him again."

Thanks, but...

Two months does not make a sample size of note! I am gald you have made some money, but be careful. There will be ups and downs and you need to be ready for those.

Crash Talk

May 15, 2006

An interesting article about crash talk (PDF). You never know when or if everything will really take off, but if markets all go sharply, trend followers will be there.

Ben Stein on Oil

Ben Stein lays out strong thoughts on the responsibility for high oil prices here (PDF). An excerpt:

"The energy companies -- by and large and with some exceptions -- just go out into the market, like you and me shopping at the grocery store, and buy oil, process it, and then sell it with a small markup to pay them for their efforts and to reward their stockholders for risk. This profit is pennies compared with what stock brokerages, software makers, and other major U.S. companies earn on a percentage basis of sales. In other words, the oil companies are just messengers announcing to energy-consuming Americans the news about oil prices."

I agree 100%. Later he adds:

"As for me, I question if the commodities boom can go on forever. I have some of the funds I just mentioned, but not a lot. Commodities booms come and go -- historically, they've never gone on forever. If you think this one will, here's a hint. When people say, "Hey, this nonstop boom has never happened before," and someone responds, "This time it's different," hold onto your wallets. "This time it's different" is one of the most frightening phrases in economics. It's entirely possible that the next move for oil is a long step down. Then won't we be sorry for shooting the messengers?"

I agree here too. The idea, the trend following mantra, is not to predict bull or bear markets, but rather to follow along the market direction with a precise plan for exit always in mind.

Grounded in Fundamentals

May 14, 2006

Review this recent article (PDF). An excerpt:

"New market high points inevitably are when many would-be investors begin to fret that everyone is getting rich but them, but the time is already past to make big money in the markets. With the Dow Jones industrials and other major market indexes flirting with historic highs, is this one of those times? A variety of investment professionals and strategists don't think so. Each expressed the belief that the U.S. equity market's steady, slow climb back from the 2002-03 trough has been driven by bedrock, fundamental strengths in the economy, not speculation. They also say there's very little reason to believe we are at a peak, with a diverse mix of inexorable demographic and economic forces, both here and abroad, pointing to sustainable underlying business performance. In short, while short-term profits in the stock market are never assured and are dodgy to predict, the long-term chances of building wealth are pretty good, even if you start investing now. Yet even in the short term, analysts say there are many good reasons to be optimistic about the stock market and the economic cycle in the next year or two."

If you follow the advice above, how does it help you to answer these questions?

1. How do you determine what market to buy or sell at any time?
2. How much of a market should you buy or sell at any time?
3. How do you determine when you enter a market?
4. How do you determine when you exit a losing position?
5. How do you determine when you exit a winning position?

9 Innings with Jeff Angus

May 13, 2006

As a former baseball catcher, I found this excerpt and associated PDF useful in thinking about trading success:

"Baseball metaphors run through business speak as easily as Willie Mays ran down fly balls. But too often, writes consultant and baseball columnist Jeff Angus in Management by Baseball (HarperCollins, May), business fails to live up to the American pastime. Fast Company (PDF) shared a bleacher with him at a spring-training game of his hometown Seattle Mariners."

In the PDF, this line caught my eye:

"It helps to think like a catcher, which is why so many become good managers. A catcher always has the whole play in front of him and can think critically about what he sees."

Technical Analysis Definitions

A definition of technical analysis seen recently:

"Technical analysis uses deviations from the efficient market hypothesis to make best guesses about future movements in the financial markets."

I have a different take in my book:

Now here is where the understanding of technical analysis gets tricky. There are essentially two forms of technical analysis. One form is based on an ability to "read" charts and use "indicators" to divine the market direction. These so-called technical traders use methods designed to attempt to predict a market direction. Here is a great example of the predictive view of technical analysis: "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 tea leaves 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 discernably better than chance as to be unexploitable because of transaction costs." This is the view of technical analysis held by the majority—that it is some form of superstition, like astrology. Technical prediction is the only application of technical analysis that the majority of Wall Streeters are aware of as evidenced by equity research from Credit Suisse First Boston: "The question of whether technical analysis works has been a topic of contention for over three decades. Can past prices forecast future performance?" However there is another type of technical analysis that neither predicts nor forecasts. This type is based on price. Trend followers form the group of technical traders that use this type of analysis. Instead of trying to predict a market direction, their strategy is to react to the market’s movements whenever they occur. Trend followers respond to what has happened rather than anticipating what will happen. They strive to keep their strategies based on statistically validated trading rules. This enables them to focus on the market and not get emotionally involved.

Google Follows Trends Now

May 12, 2006

Google is now in the business of following trends at their new site. Read about Google Trends here. Thanks to Jason Russell for the heads up.

Barry Ritholtz Follows Price Action Too

May 10, 2006

Barry Ritholtz adds a great comment on his blog:

"We could merely guess – and all these calls for buying big cap tech stocks in the face of declining stock prices, decreasing P/E multiples, and rapid commoditization of their products have been nothing more than blind guesses. However, we find it is much more advantageous to wait until a given stock, sector, index or market proves itself before leaping into the fray. This is an admittedly humble approach (surprised?). We acknowledge that the future is unknown, that us Humans are particularly bad at conjecturing what lies ahead, and that most people on Wall Street refuse to acknowledge this. We confess to having no idea what the hell is going to happen even next year. Will the GOP lose control of Congress? Will bird flu kill millions? Will Iraq get even worse? And what about Katharine McPhee – can she win it all on American Idol? We own up to having no clue about any of these burning issues. And neither, we must tell you, does anyone else. So rather than merely speculate, we would rather allow a given sector to develop on its own. When we got bullish on Oil in December 2003, crude had broken out over $30, and was heading higher. Similarly, our calls on US Equities post Tax cut in 2003 wasn’t until the technical picture improved. We got bullish on Japan in 2004 when it was apparent that it had started to work; Those who were merely “guessers” had 15 years to get it wrong. Our bullishness on Gold was for similar technical reasons – after a long period of under performance it was starting to work also. Regular readers are all too familiar with our expectations for how this bull market ends – an ugly and violent death – but as long as the trend remains up, we are loathe to fight the tape and get short. Indeed, we still are not short any US equities, although we have some in the money VIX options and a few Q puts – as hedges. While we may wax eloquent and muse about what may come eventually, our investments stay on the same side of the market as the overall trend – or at worst, in cash. Once we see proof positive that a stock, sector or market has shifted direction, then we can jump in."

Boo-yah!

May 09, 2006

From the Jim Cramer Mad Money Wikipedia entry:

"The majority of the hour features the flamboyant, colorful Cramer shouting, leaping, and gesticulating around the set and at the camera, all while providing his viewers with investment advice. Arguably, this format skews the show more towards being entertainment rather than a source of financial information. Many financial professionals attest to Cramer's skill at picking stocks and explaining principles of sound investment; the individual investors who call into the show also seem to hold Cramer's advice in high regard. Cramer himself says that the goal of his show is to entertain the viewer and provide the viewer with good, sound investment advice. Cramer is usually standing up with the fisheye lens Steadicam close to his face, zooming in and out, all the while providing his stock picks and his reasoning (with his voice inflection known to suddenly change from calm to shouting). Cramer also throws various objects on the set (papers, pencils, etc.) and even smashed up a model plane when explaining his thoughts on Boeing stock; on another episode he used a telephone receiver to destroy a computer keyboard."

I know some very smart people who refuse to say anything untoward about Cramer's show. They always say it is just entertainment and never get close to any criticism. But is it just entertainment? Do people really just watch because it is fun and wacky? I maintain people watch because at the root of the show they feel they are getting some investment value from it. The show's comedy works because it is assumed the underlying foundation of the investing advice offered is sound. Is it? The basic premise of the show is "stock tips work". Do stock tips work? Would this show have excelled in 1999? You bet. Would this show have excelled in late 2000? I don't think so. What does that say about the audience mindset giving Cramer such great ratings?

I wish Cramer all the success, but I just have an odd feeling about so many new people adopting bad habits in their understanding of the markets and trading.

Steenbarger and Mann on Risk

May 08, 2006

Brett Steenbarger and Adam Mann offer insights into 'How to Manage the Psychological Risks of Trading' (PDF). An excerpt:

"The psychologist Donald Meichenbaum introduced a technique for stress management that he called stress inoculation. He found that exposing people to low levels of an anticipated stressor helped them cope with actual stresses when they occurred. Evaluating your performance--knowing your likely drawdowns, drawups, and flat performances in advance--is a kind of stress inoculation, preparing you for the outcomes you're likely to face even when you trade well. We are well acquainted with how emotions can disrupt trading; less well appreciated is how trading can play with our heads! As in medicine, a little inoculation can go a long way toward preventing major ills."

You have to like the 'inoculation' connection. Nice 'aha!'

Compounding Magic

May 06, 2006

Here is a take on "compounding" from a reseller of the Winton Capital trend following fund:

"There's a good rule of thumb for estimating realistic returns from equities over time. Take the rate of inflation and add on a risk premium of 3%. With inflation currently at around 2.6%, you could expect returns from equities to be around 6% over the next few years. However, big external shocks can have a significant negative effect on equity markets and there is no guarantee that you will get back what you invest. The Matrix Ascension Plan aims to give you higher returns than equities over the next seven years and capital protection. The Matrix Ascension Plan enables you to benefit from the returns of a Fund managed by Winton Capital Management, a company that has a track record of producing high returns for investors. In October 1997, they launched the Winton Futures Fund which has provided investors with annualised returns of 21.01%. As a comparison,the annualised returns from the FTSE 100 Index over the same period have been 0.28%. To put these returns in some sort of context, if you had been the buyer of Vincent van Gogh's 'Irises' in 1947, you would have paid $80,000. The next time it changed hands, in 1987, it was bought for $53.9m. This seems an extraordinary rise in value but mathematically it shows a compound average annual growth rate of 17.7% - less than the annualised returns from the Winton Futures Fund over the last six and a half years."

I liked the van Gogh compounding example. It really points out the "magic" of compounding.

Richard Donchian Students

May 05, 2006

Richard Dennis is not the only teacher with many pupils still trading. Richard Donchian, now deceased, has students still going strong too.

Many of the men here (PDF) at NorthCoast Asset Management have direct working experience under Donchian.

Jason Russell Monthly Commentary

Jason Russell, who added tremendous value to my book Trend Following, is off to a nice start with his trend following fund. His April monthly letter (PDF).

Flex Retirement

May 04, 2006

A good article (PDF) on a more realistic way to view the concept of retirement. If you are still clinging to your grandfather's ideal of retirement or to what the union or big company "promised" you, better start changing your ways now. The world is too competitive to just sit back and "trust" that you will be cared for. The government, the union and or the company is not the security blanket in the real world.

What Number to Believe?

May 03, 2006

From the Enron trial comes this tidbit:

HOUSTON (AP) -- Last-minute changes to quarterly earnings reports prosecutors contend were ordered by Enron Corp. Chief Executive Jeffrey Skilling to improve the company's reputation on Wall Street were accurate, and not the result of improper tapping of company reserves, a defense expert testified Wednesday. "The whole process of financial reporting, in a company as large as Enron, to get financial statements out ... is an enormous undertaking," said Walter Rush, an accounting expert hired by Skilling. "And people are scrambling, trying to get these estimates put together. "There are changes going on up to the very last second. It is universal. Every company goes through this."

These are the comments of expert witnesses, that is a given, but still it means the financials are impossible to really know. How can you successfully forecast share price direction using fundamental analysis with company numbers you can't trust?

Arabic Translation for Trend Following

May 01, 2006

Trend Following was signed today for an Arabic translation.

Intentions

Ed Seykota offers this comment on intentions at his web site:

"Intention = Result. The thing you state as your intention may not be your real intention. In that case, you intend to not manifest your statement intention as part of a larger (secret) intention. For example, you promise to show up on time and show up late. Your intention may be to gain attention by making people wait for you."

So many people fixate on rules and techniques, but forget "intentions". As you approach your daily life, contemplating how you will find the big score, have you thought about your true intentions? The trading psychology part of the equation is just as important as the quant side of the equation.