- The Market
- Winning and Losing
- Investor v. Trader: How Do You See the World?
- Fundamental v. Technical: What Kind of Trader Are You?
- Discretionary v. Mechanical: How Do You Decide?
- Has Trend Following Changed?
- Trend Following Modus Operandi: Follow Price
- Follow the Trend
- Handling Losses
- Key Points
Fundamental v. Technical: What Kind of Trader Are You?
There are two basic theories of trading. The first theory is fundamental analysis, the study of external factors that affect the supply and demand of a particular market. Fundamental analysis pays attention to factors like weather, government policies, domestic and foreign political and economic events, price-earnings ratios, and balance sheets. By monitoring supply and demand factors, or "fundamentals" for a particular market, it is supposedly possible to predict a change in market conditions before that change has been reflected in the price of the market.
Whenever we get a period of poor performance, most investors conclude something must be fixed. They ask if the markets have changed. But trend-following presupposes change.
John W. Henry7
The vast majority of Wall Street are proponents of fundamental analysis. They are the academics, brokers, and analysts who spoke highly of the "new economy," predicting that all dot-com stocks would rise forever due to an assortment of fundamental forecasts. Millions bought into their rosy projections and rode the dot-com bubble straight up with no clue how to exit when the bubble burst.
Has anyone changed their investment strategies, or do they still need their daily fix of fundamental headlines? Evidence that nothing has changed can be found in Yahoo! Finance's commentary outlining a single day of trading in the fall of 2003:
"It started off decent, but ended up the fourth straight down day for stocks . . . early on, the indices were in the green, mostly as a continuation from the bounce Monday afternoon . . . but as the day wore on and the markets failed to show any upward momentum, the breakdown finally occurred . . . The impetus this time was attributed to the weakness in the dollar, even though the dollar was down early in the day while stocks were up . . . also, oil prices popped higher on wishful thinking statements from a Venezuelan official about OPEC cutting production . . . whether or not these factors were simply excuses for selling, or truly perceived as fundamental factors hardly matters . . . The tone is fragile and the chartists are becoming increasingly concerned about a more significant correction . . . the late, quick dip in the indices at the close didn't help . . . the corporate news was generally good . . . Home Depot (HD 34.95 -0.52) had an excellent earnings report but lost early stock gains . . . Agilent (A 27.77) also had good earnings . . . General Electric (GE 28.44 +0.63) was upgraded to 'buy' at Merrill Lynch."
One of our basic philosophical tendencies is that change is constant, change is random, and trends will reappear if we go through a period of non-trending markets. It's only a precursor to future trends and we feel if there is an extended period of non-trending markets, this really does set up a base for very dynamic trends in the future.
Former Head of Research at John W. Henry8
Millions of readers still log on to Yahoo! Finance every day, so on their behalf we ask the following questions:
Why aren't four straight down days a good thing if you are short?
Please define with a precise formula the term bounce.
Please define with a precise formula the term upward momentum.
Who attributed the impetus to weakness in the dollar? How did they do this?
Please define with a precise formula the term fragile tone.
What does the corporate news was generally good mean?
What does it say for fundamental analysis that Home Depot reported good earnings, but the stock dropped?
Merrill Lynch has issued a buy for GE. Will there ever be a sell? How much does Merrill Lynch say we should buy of GE?
Where are the facts in Yahoo!'s commentary? Where is the objectivity? One of the greatest trend followers, Ed Seykota, nails the problem of fundamental analysis with his typical good humor:
"One evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife off the edge of the table. He watched the knife twirl through the air, as it came to rest with the pointed end sticking into his shoe. 'Why didn't you move your foot?' I exclaimed. 'I was waiting for it to come back up,' he replied."9
Don't we all know an investor who is waiting for "their" market to come back? Motley Fool's home page reflects the folly of literally "banking on" fundamental analysis as a solution:
"It all started with chocolate pudding. When they were young, brothers David and Tom Gardner learned about stocks and the business world from their father at the supermarket. Dad, a lawyer and economist, would tell them, 'See that pudding? We own the company that makes it! Every time someone buys that pudding, it's good for our company. So go get some more!' The lesson stuck."10
But I think our ace in the hole is that the governments usually screw things up and don't maintain their sound money and policy coordination. And about the time we're ready to give up on what usually has worked, and proclaim that the world has now changed, the governments help us out by creating unwise policy that helps produce dislocations and trends.
David and Tom Gardner's pudding story may be cute but it is not complete. Their plan gets you in, but it doesn't tell you when to get out of the pudding stock or how much of the pudding stock you must buy. Unfortunately, many people believe their simple story is a good strategy for making money.
The second theory, technical analysis, operates in stark contrast to fundamental analysis. This approach is based on the belief that, at any given point in time, market prices reflect all known factors affecting supply and demand for that particular market. Instead of evaluating fundamental factors outside the market, technical analysis looks at the market prices themselves. Technical traders believe that a careful analysis of daily price action is an effective means of capitalizing on price trends.
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."12
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.
Mark Abraham Quantitative Capital Management, L.P.
This is the view of technical analysis held by the majoritythat 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?"13
Markets aren't chaotic, just as the seasons follow a series of predictable trends, so does price action.
Stocks are like everything else in the world: They move in trends, and trends tend to persist.
Jonathan Hoenig Portfolio Manager, Capitalistpig Hedge Fund LLC
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.
However, price analysis never allows trend followers to enter at the exact bottom of a trend or exit at the exact top of the trend. Second, with price analysis they don't have to trade every day. Instead, trend followers wait patiently for the right market conditions instead of forcing the market. Third, there are no performance goals with price analysis. Some traders might embrace a strategy that dictates, for example, "I must make $400 dollars a day." Trend followers would ask them, "Sure, but what if the markets don't move on a given day?"
One trend follower summarized the problem:
"I could not analyze 20 markets fundamentally and make money. One of the reasons [Trend Following] works is because you don't try to outthink it. You are a trend follower, not a trend predictor."14
It is not the strongest of the species that survive, nor the most intelligent, but the ones most responsive to change.