“We like to buy expectations not prices.”

If you ever see that advice, run. Reach for your wallet and run. Fast. The only true measure is the price of the instrument you are trading. An expectation, or prediction, for tomorrow is fool’s gold.

Sobering for the fundamental folks who like to think they can see tomorrow today.

Synopsis: Michael Covel opens up with some Johnny Cash. Like most of Cash’s music it’s a simple song. It’s powerful, but it works. And its simplicity is exactly why it works. Covel dedicates today’s episode to the topics of simplicity, prediction, and risk, and presents three articles revolving around each of these ideas. First, Covel mentions an article that appeared in Business Week regarding how Japan’s fear of risk is getting dangerous. For those not aware the Japanese stock market is down 76% still from its 1989 high. That would have to be an entire generation–an entire country–that no longer believes in the stock market. That’s not the reason Covel brings up the article; rather, it’s the “play it safe” mentality. He goes on to discuss the tendency to focus on downsides rather than opportunities. The attitude of risk-aversion in Japan explains why few Japanese students choose to study abroad, why regulators hold up vaccinations, and why 844 trillion yen (almost twice the country’s yearly economic output) sits idle in cash at home and in savings accounts earning 0.02% interest. We’re not far away from this attitude coming to America, but with that comes an opportunity for you to profit. Covel isn’t picking on Japan; it’s just a useful example of the risk-averse attitude that seems to be spreading. Covel moves onto an article from Golf Digest called “What Predictions Say About Us”. Predictions are about pretending to know. Covel points out one particularly compelling quote: “Human beings are wired to predict. In ancient times, predictions served as a psychological counterweight to the extreme uncertainty of life. As we’ve gained more control over this daily existence, predictions help encourage the illusion that we’re in charge of our own destiny. The more that is unknown, the greater the urge to predict.” Somehow we’ve come to think that we can predict almost everything. It’s hard-wired into us. If you can understand that so many people are destined to predict (and continually predict incorrectly) it can put you in the position to profit–if you’ve got a strategy that’s predicated on *not* predicting, i.e. trend following. Covel moves on to discuss simplicity quoting an article called “One Trick Pony”. The article talks about Peyton Manning and Tom Moore, who teamed up with a NFL strategy that they used with great success. Their strategy was based on running the fewest play concepts of any offense in the league. It’s not about trying to surprise the opponent, but in mastering a strategy that works. That’s trend following, too. It’s relatively simple, it’s robust, it’s big, and there aren’t a lot of moving parts. It is what it is–which is a great opportunity for profit. Free DVD: www.trendfollowing.com/win.

An excerpt:

…predictions are a way of demonstrating knowledge. Of course, in most things, a successful demonstration involves being right. In golf, a good argument will suffice. Most compellingly, human beings are wired to predict. In ancient times predictions served as psychological counterweight to the extreme uncertainty of life. As we’ve gained more control over daily existence, predictions help encourage the illusion that we are in charge of our own destiny. The more that is unknown, the greater the urge to predict. As the recently departed futurist author Ray Bradbury once said, “Mysteries abound where most we seek for answers.”

If you can find yourself comfortable not trying to predict daily life (and trading) there is a nice reward for you.

I don’t post this as a prediction to bet on, but rather due to my fear that if the system quakes again they will change the rules again, i.e. 2008 short bans:

Caught this excerpt on pragcap.com:

“In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.”
–Robert Wenzel, Editor of the Economic Policy Journal, speaking at the New York Fed

Continuing:

In the science of economics there are no such constants, yet investors often behave as if they operate in a world of logic and certainty. Because such assumptions are made, history is littered with investors who have failed miserably.

Rotate on those comments for a moment. Let them sink deep into your gut.

Mike Shell reminds us all about poor risk measures…and the ugly stuff that happens when relying on faulty logic. An excerpt from Pensions & Investments magazine gets 50% right (the problem) and 50% wrong (the solution):

Value-at-Risk and other popular risk measurements are typically effective during calm markets but often times are quite ineffective during challenging periods such as market shocks. More predictive models need to be used now that market volatility is high.

Predictive models as a solution?

No.

Jack White ain’t singing about VAR measures, but he does describe the end result if you rely on them or in the alternative “predictive models”:

“…stick a knife inside me, and twist it all around.”
“…grab my fingers gently slam them in a doorway put my face into the ground.”

If you want those feelings, go VAR and or prediction. Guarantee you will find all kinds of pain…in your account.

Note: Song is great.

Just another week. Equity markets down, up, down. Non-stop news. No predictability, but lots of fundamental explanations:

NEW YORK (Reuters) – U.S. stocks closed their worst two-week slide since November with a selloff on Friday as disappointing China growth data sparked worries the global recovery was flagging.

Concerns that Europe’s debt crisis was flaring up again added to selling pressure. Sectors taking the hardest hit were those most closely linked to growth, including materials, energy and financials.

The S&P 500 is now down 3.4 percent from this year’s closing high, after falling 2.7 percent over the past two weeks.

“Everyone is looking for global growth, but the slowing in China and the rising yields in Europe are creating questions about how strong we might expect it to be,” said Brad Sorensen, director of market and sector analysis at Charles Schwab in Denver. “That’s leading to a correction here, with financials especially taking a hit.”

Got a migraine headache yet? Let’s get practical. Answer the following five questions, and you have a trend following trading system–answers that can get you past reliance on the nonstop 24/7 financial spin cyvle:

1. What market do you buy or sell at any time?
2. How much of a market do you buy or sell at any time?
3. When do you buy or sell a market?
4. When do you get out of a losing position?
5. When do you get out of a winning position?

Said another way:

1. What is the state of the market?
2. What is the volatility of the market?
3. What is the equity being traded?
4. What is the system or the trading orientation?
5. What is the risk aversion of the trader or client?

You want to be black or white with this. You do not want gray. If you can accept that mentality, you have got it. Some might say, “Oh, I have a system.” What he typically means is that he has a system, and it advises him what to do. If he likes the advice, he’ll take it, and if he doesn’t like the advice, he won’t take it. That’s not a system, that’s the same as following the news.

From Wikipedia:

“Vito tells Michael that Barzini would set him up to be killed… Barzini would use a trusted member of the Corleone family as an intermediary, and that whoever came to Michael about the meeting with Barzini was a traitor.”

Can we apply the same logic to anyone who tries to explain why equity indexes were down April 10, 2012? And for those who immediately say WTF to my Godfather quotation, of course the point is that NO ONE can explain exactly some one day of market movement. It’s the great example, yet again, of fundamental analysis as a pants at your ankles investing strategy. So the question becomes, as Vito notes, is the one who comes explaining today’s market movement worth trusting?

From a reader:

Dear Micheal [sic], Finally, there is no doubt left for the direction of the DOW. It’s obvious that it’s heading upward targeting to complete the 4th swing of its long term expanding triangle. Precise target of the swing is 15.600,6 as of March 19, 2012 which is the touching point for the DOW at the upper bound line of the formation. Each day passing lifts the target for the swing up by around 6 DOW points for every week due to increasing nature of the upper bound line of the formation. After completion of the formation, we’ll face with a nightmare, a very bearish trend targeting at least 5.000 Dow points as 5th swing of the formation. Note the amazing and perfect oscillation around 10,000 for 12 years. It will continue to the completion of the 5th swing until around 2016-2017. Please see attached the excel file for the daily target calculation.

My response comes from a video circa 1980:

Did my video response make any sense? That’s my point.

Your life will be much nicer over the long haul if you read something like this and know that Kass has no more clue about tomorrow …than you do.

Barry Ritholtz linked to a nice piece on prediction. An excerpt:

Prediction should be all about risk, uncertainty, and likelihood, but what you’ll hear this week and throughout the year is a chorus of experts telling you with great certainty what the future will bring. Don’t believe them. If you’re jonesing for advice, try listening to those who are providing detail on probability, risk and trends. But know that the future is never about certainty and always about probability. When prognosticators get it right, they were just plain lucky. They may have played the odds.They may have had some truly intuitive insight that others did not. But there is never a sure thing.

I hate reading smart stuff. It is so much easier to slurp Kool-aid.

Think of it this way: If half of the time your trades go in your direction, you are hitting a good average. Even being right three or four times out of ten will yield a windfall if your losses are cut quickly when you are wrong.

You will never get in at the beginning of a trend or get out at the top. Picking tops and bottoms is not the objective. Think about the often repeated phrase: profit targets. Problem? They cap profits. For example, you enter some market at price level 100 and you decide that you will exit if the price hits 125. That may sound rational, but it is ignorant when re-evaluated.

If you are riding a trend, you have to let it go as far as it can go. You need to fully exploit the length of the move. You do not want to exit at 125 and watch the trend go to 225.

You need home run trends to pay for your small losses. If you are artificially creating a profit target for no other reason than comfort, you are prematurely stopping those potential big trends that actually get you rich. It’s a vicious circle if you do not handle it properly from the beginning.

Mark Abraham, part of Abraham Trading, has made the point clear:

“While a fundamental analyst may be able to properly evaluate the economics underlying a stock, I do not believe they can predict how the masses will process this same information. Ultimately, it is the dollar-weighted collective opinion of all market participants that determines whether a stock goes up or down. This consensus is revealed by analyzing price.”

Erudite. More? See: Trend Following book.

Give Rod Serling credit for figuring it all out back in 1960, and give him more credit for burying it in an episode of The Twilight Zone:

Alien visitor #1: Understand the procedure now? Just stop a few of their machines and radios and telephones and lawn mowers…throw them into darkness for a few hours, and then just sit back and watch the pattern.

Alien visitor #2: And this pattern is always the same?

Alien visitor #1: With few variations. They pick the most dangerous enemy they can find and it’s…themselves. All we need to do is sit back…and watch.

Popular delusions are a foundation of trend following profit? You bet. Since 1929 there have been 18 market crashes. Clearly, 100-year floods actually happen far more frequently…