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This chapter is from the book

In Plain Sight

Trend following is not something new. It goes back decades. The strategy is simply discovered by new generations of traders at different times:

  • “Salem Abraham, a trend following trader, began researching the markets by asking a simple question: Who is making money? The answer was trend followers and his journey began.”19

But few people have made the journey with Abraham. During the dot-com era of the late 1990s, during the 2008 real estate and credit bubbles, so many investors and traders with so little strategy were making so much money that trend followers disappeared from the radar screen, even though they kept right on making money.

Since trend following has nothing to do with short-term trading, cutting edge technologies, or Wall Street Holy Grails, its appeal is always negligible during market bubbles. It’s not sexy. If investors can jump on the bandwagon of practically any “long only” mutual or hedge fund manager or turn a profit trading themselves by simply buying Internet, energy, or real estate stocks and holding on to them, what need would there ever be to adopt a strategy such as trend following?

However, if we look at how much money trend followers have made since assorted stock market bubbles have popped, trend following becomes far more relevant to the bottom line. The following chart (Chart 1.1) shows a hypothetical index of three longtime trend following firms compared against the S&P stock index. The chart combines Dunn Capital Management, Campbell and Co., and John W. Henry and Co. into an equally weighted index:

Chart 1.1

Chart 1.1 Trend Following Index Compared to S&P and NASDAQ

Yet, even when trend following success is brought to their attention, investors are often skeptical. They say the markets have changed and that trend following no longer works. Their concerns usually stem from a random press story of a trend follower who supposedly “blew up” and lost all of his clients’ money. But the truth is that trend following hasn’t changed, even though a single trend follower may make a mistake.

Let’s put change in perspective. Markets behave the same as they did 300 years ago. In other words, markets are the same today because they always change. This is the philosophical underpinning of trend following trading. A few years ago, for example, German mark trading had significant trading volume. Now the Euro has replaced the German mark. This was a huge, yet typical, change. If you are flexible, market changes, like changes in life, don’t have to impact you negatively. Trend traders traded the mark; now they trade the Euro.

Accepting the inevitability of change is the first step to understanding trend following philosophy. One trend follower describes the benefits of understanding change:

  • “But what won’t change? Change. When a period of difficult performance continues, however, most investors’ natural conclusion is that something must be done to fix the problem. Having been through these draw downs before, we know that they are unpleasant, but they do not signal that something is necessarily wrong with the future. During these periods, almost everyone asks the same question in these exact words: ‘Have the markets changed?’ I always tell them the truth: ‘Yes.’ Not only have they changed, but they will continue to change as they have throughout history and certainly throughout our 19 years. Trend following presupposes change. It is based on change.”21

Markets go up, down, and sideways. They trend. They flow. They surprise. No one can forecast a trend’s beginning or end until it becomes a matter of record, just like the weather. However, if your trading strategy is designed to adapt to change, you can take advantage of the changes to make money as John W. Henry noted:

  • “If you have a valid basic philosophy, the fact that things change turns out to be a benefit. At least you can survive. At the very least, you will survive over the long term. But if you don’t have a valid basic philosophy, you won’t be successful because change will eventually kill you. I knew I could not predict anything, and that is why we decided to follow trends, and that is why we’ve been so successful. We simply follow trends. No matter how ridiculous those trends appear to be at the beginning, and no matter how extended or how irrational they seem at the end, we follow trends.”22

What does Henry mean by “a valid basic philosophy?” He is talking about a trading strategy that can be defined, quantified, written down, and measured in terms of numbers—as a way to track trends. Do you have one of those? Does your broker have one? Does your mutual fund manager have one? Does your high-flying hedge fund have one? Trend followers do not guess if they must buy or sell. They know what to do because they have their “valid basic philosophy” codified in a specific plan. What is behind the source of those trends, those profits? The Man Group, one of the largest trend following traders, sees “trends as a persistent price phenomenon that stem[s] from changes in risk premiums—the amount of return investors demand to compensate the risks they are taking. Risk premiums vary massively over time in response to new market information, changes in economic environment, or even intangible factors such as shifts in investor sentiment. When risk premiums decrease or increase, underlying assets have to be priced again. Because investors typically have different expectations, large shifts in markets result over several months or even years as expectations are gradually adjusted. As long as there is uncertainty about the future, there will be trends for [trend followers] to capture.”

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