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

Mankiw’s Ten Principles of Economics, Translated

February 28, 2007

"The cornerstone of Harvard professor N. Gregory Mankiw’s introductory economics textbook, Principles of Economics, is a synthesis of economic thought into Ten Principles of Economics."

What are those and what do they really mean? Read.

Mankiw’s Principles:

#1. People face tradeoffs.
#2. The cost of something is what you give up to get it.
#3. Rational people think at the margin.
#4. People respond to incentives.
#5. Trade can make everyone better off.
#6. Markets are usually a good way to organize economic activity.
#7. Governments can sometimes improve market outcomes.
#8. A country’s standard of living depends on its ability to produce goods and services.
#9. Prices rise when the government prints too much money.
#10. Society faces a short-run tradeoff between inflation and unemployment.

Yoram’s Translations

#1. Choices are bad.
#2. Choices are really bad.
#3. People are stupid.
#4. People aren’t that stupid.
#5. Trade can make everyone worse off.
#6. Governments are stupid.
#7. Governments aren’t that stupid.
#8. Blah blah blah.
#9. Blah blah blah.
#10. Blah blah blah.

The Aftermath

A day after an equity market mini-correction, "news" fills the air at Yahoo! Finance:

"It's typical that you get a bounceback the next day," said Joseph V. Battipaglia, chief investment officer at Ryan Beck & Co. "Now we're essentially flat on the year. Can we go up from here or down? That sorting-out process will continue now."

I don't know what anyone could do with those comments. They probably sound great to some, but in terms of usefulness, they serve scant purpose. That said, some players were more careful:

Bernanke let the lawmakers know he wouldn't be led into publicly contemplating what role Greenspan's remarks or any other developments had played in setting off the worst one-day point drop since Sept. 17, 2001, after the terrorist attacks. "I don't think it would be useful for me to try to parse the movement into the components associated with different pieces of news or pieces of information," he said.

That is a refreshing piece of candor. No attempt to give an immediately circumspect "why" answer.

Down Day for Stocks

February 27, 2007

From the Street.com today:

"The market has been stretched for the last three months, and there's been lots of speculation," said Phillip Roth, chief technical market analyst with Miller Tabak. "It's been destined to crack, but no one knew which trigger would do it."

1. A market is stretched? A market is a market. There is a price every day. They don't stretch either up or down. They do go up and down.
2. There is always speculation in markets. Same as it was a 100 years ago, 10 years ago, 1 year ago and today. Nothing new.
3. "Destined to crack" will always be a subjective statement.
4. When a market goes up or down, fast or slow, there is never a way to truly know the "trigger".

What to make out of today? What's the big lesson? Stocks went down. You don't like that answer? You want a story? You want to feel better by attempting to "understand"? There are lot's of folks who can make you feel better with endless "why" theories. I am not one of them.

The Motley Fool Is Only Feeding Demand

February 26, 2007

From Motley Fool comes this "wisdom":

It's YOUR money. According to this prominent Wall Street whistleblower, those high-priced investment types are getting high on YOUR commissions. And you won't believe the other dirty secrets this gentleman revealed to us about the teeming underbelly of the financial services industry. You owe it to yourself to hear every word! Because only then — once you know the full truth — can you decide for yourself whether you want to continue feeding Wall Street's insatiable addiction. Or if you should keep your money where it belongs... in your own account, compounding exponentially into a private fortune for you and your family to enjoy. You Absolutely Can Do It It's not even hard. You simply need to buy and hold the very best U.S. stocks. These are the opportunities that make investors truly wealthy, gaining in excess of 22.8% per year.

This kind of writing only exists because people want it to exist. Give "The Fool" credit for feeding the demand and building a business that makes money. Of course, their writing is 100% BS.

Hedge Funds Are Scary! Success Is Frightening!

February 25, 2007

One view on hedge funds from Loren Steffy of the Houston Chronicle:

Hedge funds need latitude to maintain the kind of returns that makes them attractive to investors. Instead of buying only stocks and bonds, for example, hedge funds make riskier plays. They may buy an entire company, restructure it, and sell it a few years later for a big profit. They may buy and sell stocks by the hour. They may sell stocks short, betting, essentially, that the stock will fall in value. They may dabble in derivatives, currencies, collateralized mortgage options or the swap market. Or all the above. All that risk, of course, doesn't always lead to reward. Last year, about 5 percent of all hedge funds failed, according to Hennessee Group, a New York-based hedge fund consultant. A typical fund has about a three-year life span. But the hedge funds that succeed do so precisely because they are free of restrictions. That creates a double-edged financial sword for investors, because hedge funds provide an important function. The markets need them. Hedge funds sop up risk, which helps reduce volatility, and they employ tactics such as short-selling that make markets more efficient. A study by the Federal Reserve Bank of Cleveland last year found that hedge funds tend to reduce price volatility in the market. That's why Paulson and his fellow regulators are reluctant to offer investors more than platitudes. For most of us, though, the best way to benefit from hedge funds is to stay out of their way. So take my advice. If you're thinking a hedge fund may be the right investment for you, it probably isn't.

Loren is right. Immediately go hide under your bed. Put your money under your mattress. Eventually you will be dead and the fear will subside!

It appears investors don't agree with him: read (PDF).

Hedge Fund Resources at Harvard

A hedge fund resource site at Harvard.

Faux Experts

Following up on my post the other day about Nassim Taleb, I found a question/answer with him about his new book The Black Swan:

Q: What do you want people to take away from reading your book?

A: How not to be a fool for things that matter. You can take advantage of uncertainty if you know how to look it in the eye, and know the limits of what we understand. You should learn to accept fuzziness and know that we know very little in some domains, but that it can be so useful a guidance to reality. How to avoid taking seriously the "faux experts" (those who wear suits and act in a pompous way). How listening to the media, or studying economics, degrades your knowledge of the world.

His advice is straightforward and very on target, but how many people will really stop to reflect on his words?

Black Swan Glossary

February 23, 2007

The Black Swan Glossary (PDF) from Nassim Taleb. Good reading.

A Quantitative Approach to Tactical Asset Allocation

Feedback in tonight from Mebane T. Faber:

You linked to my white paper awhile back. A newer version was recently published in the Journal of Wealth Management. The Journal of Wealth Management link is here, and the free SSRN version is here.

Risk and Fear

February 21, 2007

Ed Seykota gave an insightful explanation on risk management recently on his site:

Risk is a combination of the possibility of a loss and the magnitude of the loss. We register risk in our bodies as a feeling of fear. One way to manage various forms of risk, including prospective risk, initial risk, open risk, and unconscious risk it to make sure your feeling of fear is an ally, fully functioning on your emotional instrument panel. In our medicinal culture, some people attempt to medicate fear, rather than manage risk...In general, people with willingness to experience fear and other feelings are better risk managers than those who have fear in k-nots or fear under the influence of narcotics.

The Folly of Predictions

I was emailed a quote today from Ulf af Trolle (Swedish business consultant):

"If you really have to make an economical prediction, then follow this golden rule: Make the prediction optimistic. If you are right, then you will get a reputation to be extraordinary skilled. If you are wrong people will sympathize with you. At least you did your best. If you instead make a pessimistic prediction, and get it wrong, then you are a klutz. And if you are right, then you will be blamed for creating the situation."

A very nice summation on the folly of predictions!

A Betting Game

February 20, 2007

A good quote from Larry Hite:

“There are just four kinds of bets. There are good bets, bad bets, bets that you win, and bets that you lose. Winning a bad bet can be the most dangerous outcome of all, because a success of that kind can encourage you to take more bad bets in the future, when the odds will be running against you. You can also lose a good bet, no matter how sound the underlying proposition, but if you keep placing good bets, over time, the law of averages will be working for you.”

Controlling Emotions is Not the Goal of Trading Psychology

February 19, 2007

Controlling Emotions is Not the Goal of Trading Psychology (.doc) by Brett Steenbarger.

Tricks to Soften the Pain of Saving

This WSJ article by Jonathan Clements caught my eye:

My check register says my checking-account balance is perilously close to zero. Yet, in truth, there is $4,000 or $5,000 in the account. Sound weird? It is. But let's face it: If we were all completely rational, we wouldn't have any problems managing money -- and we certainly wouldn't have a negative savings rate in the U.S.

Continue reading Tricks to Soften the Pain of Saving »

Mark Cuban on Preparation

February 18, 2007

I found a good excerpt on Mark Cuban's blog. He attended Indiana University when Bob Knight was the basketball coach. Cuban was reflecting on what was the greatest thing learned from the famed basketball coach:

When I was at Indiana you were on 60 Minutes. In your interview you said one single thing that I took to heart. I reminded myself of it while it was in school at Indiana. I reminded myself of it when I failed. I reminded myself of it before any of the many businesses I have started I will continue to remind myself before any of my endeavors going forward. Its also the best advice I've been able to give people of any age who ask me for advice. Its also the characteristic I look for when choosing a partner or hiring...You said, and I'm paraphrasing: "Everyone has got the will to win, its only those with the will to prepare that do win." Words for every athlete and those of us who partake in the Sport of Business to live by.

Trading rules, or a good entrepreneurial plan if pursuing some business idea, are important, but that will to prepare is even more critical.

Very Little Data for Decision-Making?

February 17, 2007

Carla Mozee at MarketWatch writes on Feb 17, 2007:

SAN FRANCISCO (MarketWatch) -- U.S. stocks are expected to drift lower next week, as a light lineup of economic data and a dwindling number of corporate earnings reports leaves investors searching for direction after a week of record highs for the Dow Jones Industrial Average, strategists said. Other factors that could weigh on stock trading include predictions that first-quarter earnings growth is set to ratchet down, concern about a possible rate increase in Japan and the closing of stock markets on Monday for Presidents Day, they said. "Earnings season is winding down, there's very little data, it's a short week. We'll come down on the market's own inertia, so to speak," said Donald Selkin, director of equity research at Joseph Stevens. Selkin said he expects any move downward, however, to be "short and shallow" following the pattern of declines in the market since July. The only way the market could advance substantially next week would be if a significant development such as a "very big buyout" deal occurred, said Paul Mendelsohn, chief investment strategist at Windham Financial Services.

What struck me about this excerpt is the comment about the lack of "data". It all depends doesn't it? If your decision-making is driven by "price analysis" then "other" data is only so relevant. Will there ever be any consistent reporting showing anything other than a 100% fundamentally driven fixation?

"No Way It Works!"

February 16, 2007

I caught this criticism of trend following recently:

"Not only is trend following invalid statistically but, looking at the bigger picture, it has to be invalid logically without even running your unusual tests. If wealth distribution is to remain in the range of 20 to 80, trend following cannot exist. In other words, if the majority followed the trend (hence the concept of trends), and if trend following is in fact profitable, the majority will become rich and the 20-80 distribution will collapse...So in brief, no - trends do not exists and can not exist either statistically or logically, with the exception of the forever upward drift of population and general markets with some curves steeper than others, those of the countries with the extra weapon called land and immigration."

I am assuming this guy would argue that every dollar ever made by a trend following trader was just dumb luck? Don't the performance numbers mean something to a guy like this? Of course, trend following is really about answering these 5 questions:

* How do you determine what market to buy or sell at any time?
* How much of a market do you buy or sell at any time?
* How do you determine when you buy or sell a market?
* How do you determine when you get out of a losing position?
* How do you determine when you get out of a winning position?

At the end of the day everyone needs a trend to make money, but the five questions are where the rubber meets the road.

It's Still Mean Reversion

February 15, 2007

An email came in:

I think there is a problem here with naive trend following using the daily data. Even if crude goes to the moon, say $100, and you capture the $50 by trend following, one would need a million dollar account to ride one contract very comfortably on daily data. On the other hand, if one wasn't so concerned about big picture direction and trend followed shorter duration moves long and short in the hourly data, one could comfortably trend follow crude oil with a much smaller account (or larger position with the big account).

Of course it is not impossible to be a short term trader. There are simply trade-offs. Transactions costs are a big issue. Trying to be Jim Simons is an issue. Mean reversion is worth considering too.

Blackstar Funds Update

February 13, 2007

I like to post well put together performance reviews as they are educational. Cole Wilcox of Blackstar Funds provided a nice piece of research regarding trend following on stocks last year. Their February 2007 performance review (PDF) is well done too.

Ed Seykota on "Trends"

February 10, 2007

Ed Seykota offers insight for those trying to find trends.

Chuck Cain: A Graphical Inquiry into Trend Following

Chuck Cain sent in A Graphical Inquiry into Trend Following (PDF).

Short Term Trend Following?

February 09, 2007

Feedback in from the other day:

One advantage I sincerely admire in Trend Following is its simplicity and elegance. Rather than using chart patterns and the like and making many trades during one day or a week... it simply follows the trend, and I truly believe thats where the real money is made. But I have one question I am sure you have received from other traders: Don't trends occur in all time frames? I believe a trader that is using technical analysis and chart patterns to identify an edge where a trend will begin to unfold or carry on, and captures this trend, whether it be over a one day period, or a one month period can be said to be trend following. I know you have spoken and wrote about "short-term" trading... but at the least in theory, it tries to achieve maximum efficiency. Only being in a trend that is currently moving, exiting near the short-term break of a trend, and buying near support of the trend... Is this not a common sense way of maximizing gains? Some trend followers stay in trends that do carry on for months and years but have major corrections where they would have been suited to take profits sooner and sit out the major correction or consolidation and/or look to buy near the support of a trend. I am currently using a swing-trading approach and a intermediate-term trend following approach.

Transaction costs are a big argument against very short term trading. In terms of some of your terms used, it would be wise to define exactly what you mean by 'technical analysis', 'chart patterns', 'maximum efficiency', 'support of the trend', 'take profits sooner', 'major correction', 'consolidation' and 'swing-trading'. Those terms can mean anything.

Also Looking for Performance

February 07, 2007

This guy has been writing in for a while now. His latest:

Mr. Covel: In the interest of trying to figure out the efficacy of trending et al, I did a search for CTA returns. I came up with the Barclay Index; this may or may not be germane, but if it's right, the average returns aren't anything to write home about. If I have it wrong, then please point me in the direction for information as to what these great and not so great traders get in the way of returns.

The same answer applies. It is worth noting that this reader does have my book.

"No Performance" Criticism

February 06, 2007

I found this excerpt from a criticism of this site:

One of the brilliant marketing tactics used on the site is the continuous repetition of the open question "Why are they (the TF managers) so rich?". The question is offered as a sophist response to the real world question as to whether TF makes money. The marketing brilliance lies in the fact that there is never a need to provide factual support or performance records.

The performance data on pages 299-354 of my book Trend Following is clearly a mirage. I agree! Those pages don't really exist.

More on a Proof

February 05, 2007

Feedback from this post:

If it helps, a mathematical "proof" for the efficacy of trend following might be simpler than supposed. In any given trading system (trend-following or otherwise), your long term win-size to loss-size ratio (essentially your "betting odds") must be greater than the ratio of your number of losses to number of wins in order to be a worthwhile endeavor. When the ratios are equal, you win 50% of the time, and your wins are the same size as your losses. No point in trading that system. If the win-to-loss ratio is less than the number of losses-to-wins ratio, then you're losing money, and there's no point in trading that system either. Unfortunately, a real proof would have to demonstrate that all the systems that your reader defines as "trend-following" behave in such a way as to exhibit that positive win-to-loss : losses-to-wins inequality. Perhaps your reader could define all systems that can be labeled "trend-following" first. It would then be up to the same reader to find an example of trading data that was statistically significant (more than 50 trades, let's say) wherein any of those given systems does not produce a positive effect. Given the instance of a losing system, your reader could then triumphantly conclude that not *all* trend-following systems "work," but merely a percentage of them.

A View on Trend Following

An interesting exchange about trend following trading just forwarded to me.

Ed Thorp: Beat the Dealer

A quick note on Ed Thorp from Time (PDF).

A View on the Government Regulating Opportunity

Here is a comment from a reader, Eric Rupert, placed on the SEC website concerning S7-25-06. This stems from my prior post:

I am offering comment on the portion of File No. S7-25-06 that proposes redefining what constitutes an 'accredited investor'. I would like to begin by reviewing what 'investment' choices that are currently available to non-accredited investors. As a non-accredited investor I currently am able to enjoy the safety of the following investment options:

Thank you for your consideration.

John Mauldin on New Hedge Fund Regulations

February 03, 2007

'A New Definition of Rich' by John Mauldin offers some sobering analysis. An excerpt worth reading:

I am in South Africa as this week's letter is being sent out; so it is with some irony that the letter is focused on a topic that generally concerns only US-based investors, although what the SEC does has an effect on regulatory bodies abroad. This is a letter you may want to forward to your friends and associates. The Securities and Exchange Commission (SEC) has posted a new proposed rule that would raise the minimum net-worth requirement needed to invest in private funds from $1,000,000 total net worth to $2.5 million liquid net worth. This is a major change, and it means that some 7% of American households will no longer be able to invest in private offerings. In my opinion, it is likely to become law in the not too distant future unless there is significant public comment. This week we look at the proposed rule and some of its consequences, as well as a very interesting proposal by SEC commissioner Roel Campos.

Continue reading John Mauldin on New Hedge Fund Regulations »

Play for Position, Not Performance, in Your Portfolio

February 02, 2007

Jonathan Hoenig makes some interesting points here. An excerpt:

"...most of the artistic world is subjective. One person's trash is another's treasure. But trading is just the opposite - it's unabashedly objective. Numbers don't lie. You're either in the black or not. We've often pointed out that the only reason to invest in anything is to make money. Talk is cheap and performance is the only thing that really matters. So it might surprise you that, on a daily basis, I don't keep precise tabs on my fund's monthly or year-to-date performance. At any given moment, I'll have a general estimate of where I stand, but as a rule I try and tune out the exact score. Why? If performance is all that matters, why would I avoid following the exact return? The answer is because trading is like chess, not weightlifting. It's not an endeavor that's won or lost in one day depending how hard you flex your financial muscles. It's a finesse game; it's strategy. So you think and play for position, looking to set up exposures that are likely to unfold slowly over the next six months...not 60 seconds."

Amaranth Revisited

February 01, 2007

An excerpt from WSJ story on Amaranth:

How much the investors in Amaranth will lose depends on when they got in. They've gotten back about $1.6 billion to date. For one investor that came in in mid-2005, money returned so far comes to 27% of what it put in and about 18% of what its stake was worth at the peak. Investors will receive somewhat more when Amaranth finishes liquidating. Some investors have a keepsake. Amaranth once sent chess sets as year-end gifts, inscribed with a quotation from the late grandmaster Alexander Kotov: "It often happens that a player carries out a deep and complicated calculation, but fails to spot something elementary right at the first move."