Why it’s important to understand trend following

Trend Following Clarification

Trend following confusion never seems to end. Here is a view on my book Trend Following that just came in:

“A frequent (and valid) criticism of the book Trend Following is that its author often says the word “trend following” when in fact what he means is “mechanical systems trading” in general — forgetting that there
(are) several major classes of mechanical systems, only one of which is trend following.”

No, that’s not what I mean. The book Trend Following is about long-term trend following trading. It lays out with detail the men who trade this way. Most trend followers are systematic, but the decision to systematically trade comes only after making the decision to trade as a trend follower. Trend following trading is a style. It is a method based on a philosophy. On the other hand, “systems trading” means nothing in the abstract unless you define what kind of system it is.

The Pedigree

I was at a local Town function recently near where I live. An older gentleman walked in with a copy of Burton G. Malkiel’s A Random Walk Down Wall Street. For a quick refresher, here is the Publishers Weekly review of Malkiel’s book:

The eternal truth of this updated investment classic, originally published in 1973, is simple: you can’t beat the market. Well, technically, you can beat the market, but not profitably, because the transaction costs of your brilliant trading will eat up the extra returns. You can also beat the market by pure luck-but you can’t deliberately beat the market, because you can’t predict future stock prices. You can’t predict them by divining Wall Street’s crowd psychology; or by charting trends in stock prices; or by doing lots of research on companies’ business prospects. You can’t predict them from hemlines (though there’s been “some evidence” for correlation between skirt length and market prices in the past, Malkiel poo-poos future possibilities) or Super Bowl winners (this, he says, makes “no sense”). In fact, according to the efficient market theory, which states that all knowable information about a stock’s value is already reflected in its share price, you can’t predict them at all.

Back to my story. I said to him in a very pleasant way, “There are some problems with your book.” He was surprised I recognized it or knew anything about it. He wanted to chat. He then told me of his background. Taught at Princeton. Graduate School at University of Chicago and a career at the Federal Reserve. Impressive background. We kept talking. I mentioned that my book laid out contradictory information to Malkiel’s long-time bestseller. Guess what happened? Nothing. He did not want any debate. No new information was desired that might upset his long held view and he got away from me fast. However, I did find his address in the phone book and sent him a copy of Trend Following.

Trend Following Performance: A Big March

Take a look at this graphic screenshot from trend follower John W. Henry’s Financial and Metals portfolio. Henry had a good March up +11%. March 2006 commentary from JWH’s President Mark Rzepczynski starting with an excerpt he used from an Orson Welles movie about finding your edge:

Jake: What’s a tough guy?

Michael: I don’t know.

Jake: A guy with an edge. What makes him sing better than me? Something in here. What makes it loud? A microphone. That’s his edge.

Michael: Edge?

Jake: A gun, a nightstick or a razor. Something the other guy ain’t got. An extra reach on a punch, instead of brass knuckles, a stripe on a sleeve…a badge that says ‘cop’ on it, a rock in your hand…or a bankroll in your pocket. That’s an edge, brother. Without an edge, there ain’t no tough guy.

“Orson Welles could have been speaking about hedge funds, CTAs or managed futures – with that piece of dia- logue from ‘The Lady from Shanghai’. We are no tough guy, yet when there is a period of poor performance, there could be the belief that a manager has lost his edge. We have not lost our edge because it is instilled in our behavior. Our edge is simple. We stick to our discipline and stay focused. Many times during a drawdown man- agers will switch models and style in order to capture the current market behavior. We stick with our systems and follow the trend. We know that there will be periods of choppy and sideways performance. It is part of market behavior and has to be minimized; however, we also believe that trends will be created by the natural ebb and flow of markets. We have made portfolio adjustments to account for changing correlations and market liquidity. We have also changed allocations across models in an attempt to min- imize downside, but we have continued to maintain our quantitative style that depends on trends. It is not an edge based on believing that we are smarter than the rest of the market, but on the idea that focus will allow us to be placed in a position to attract the most out of market displacements when they do occur.”

Mark S. Rzepczynski

John W. Henry and Co.

John W. Henry is not the only trend follower to see a big March 2006: Read the March 2006 Superfund Report. Superfund is Christian Baha’s trend following trading firm based out of Monaco.

Lee Ainslie of Maverick Capital

Lee Ainslie of Maverick Capital gave an insightful interview (PDF) recently. Here is an excerpt:

Q: What makes you say, “Yes, we want to invest” or “No, we don’t”?

Ainslie: First and foremost, we’re trying to understand the business. How sustainable is growth?…

Ainslie has made a ton of money. Can’t argue with that. His view of the markets, however, is much different than trend following. Trend followers don’t try to understand the business. They just follow the price, up or down, long or short – for profit.

Jim Cramer on Google: Follow Along

This blurb from Jim Cramer’s web site offers great food for thought. Consider an outline of Cramer’s advice for Google (GOOG):

December 20…..Hold…..$429.74 (sell at $446)

January 3……….Buy…….$435.23 (going to $500)

January 4……….Buy…….$445.24 (going to $500)

January 13……..Buy…….$466.25 (going to $600)

January 23……..Buy…….$427.50

January 25……..Buy…….$433.00 (take profits)

February 2……..Buy…….$396.04

February 6……..Sell…….$385.10 (sell at $400)

February 14……Buy…….$343.32

February 27……Buy…….$390.38 (going to $500)

March 6………….Sell…….$368.10 (going down $15)

March 7………….Buy…….$364.45

March 13………..Sell…….$337.06

March 21………..Sell…….$339.92

March 23………..Buy…….$341.89

March 29………..Sell…….$394.98

If you are a regular viewer of Cramer’s Mad Money TV show, can you explain the logic of this to me?

Michael W. Covel is the founder and President of Trend Following. A researcher of the most successful Trend Following investment managers, he has been in the alternative investments industry consulting on Trend Following to individual traders, hedge funds and banks for ten years. His best selling book, Trend Following: How Great Traders Make Millions in Up or Down Markets, New Expanded Edition (Prentice Hall, November 2005) is a complete and concise guide to trend following. It includes interviews with great trend followers who have won millions if not billions in the market. The trading world has embraced the book with endorsements from Van K. Tharp, John Mauldin, Ed Seykota and many more. Trend Following is now in its fifth printing, and is currently available in a Japanese translation with Chinese, German, French, Korean and Russian translations soon to follow. Teaching and sharing unique insights about Trend Following trading and alternative investments has earned Mr. Covel respect as a rational and logical voice in uncertain times. Mr. Covel also writes for numerous industry publications including Your Trading Edge, Stocks, Futures and Options Magazine and International Petroleum Finance and is consistently quoted and interviewed by a variety of financial publications.

Mr. Covel is also Managing Editor at TurtleTrader.com, the leading Trend Following news and commentary resource since 1996. Thousands of visitors from more than 70 countries as well as hundreds of trading professionals engaged in years of debate and interchange making the site the rich archive of trading information, data and opinion that it continues to be today. TurtleTrader, one of the largest & strongest trading community on the web with over 7.5 million unique visitors since its inception, also functions as a resource center for the Trend Following Educational Course.