25 April 2009 – The Aleph Blog

Book Review: Trend Following (2)

Posted on 25 April 2009 by David Merkel

I had a long debate inside myself before writing my book review last night.? I could have written the review recommending purchase of Trend Following, because it teaches a truth that often gets ignored in the market — following price momentum pays around 80% of the time.? As a value investor, that was a hard lesson for me to learn, but I accepted it once the evidence was clear enough.

Why I did not recommend the purchase of the book was more over tone and style.? Here are two examples: on pages 294-296, he discusses this paper that shows that Commodity Trading Advisor [CTA] performance is little better than T-bills.? There is one substantive complaint, and I agree with it, that the Sharpe ratio is a lousy measure of performance.? Most of the other arguments focus on the author’s affiliations — AIG Financial Products and Vanguard.? It is not valid to dismiss evidence off of the background of the individual.? Deal with his arguments.? So what if he worked for AIGFP?? That doesn’t make him liable for everything done there.? Same for Vanguard.? Merely because you work for Vanguard does not mean that you shill for mutual fund industry in everything that you do.

Humble Student of the Markets Cam Hui raises these objections in his comments to my piece last night.? I object to the ad hominem arguments of Mr. Covel.? If we must argue, let us argue on the basis of principle, and may the best side win.

Now, when Mr. Covel responded to me, it was also an ad hominem argument, tying me to Jim Cramer.? Now note, the first piece has disappeared from the internet, and I know not why.? Perhaps he gets that I am not a Jim Cramer clone.? To my readers I ask, how many of you think that I am like Jim Cramer in the way I advise?? I wrote a long series of articles on using investment advice to inoculate people against using stock tips from the media, partially because as Jim Cramer became more of a media phenomenon, his recommendations became worse.? He is at his best when he writes/says less, and gives you his considered opinion.? Investing and doing something sensational for the media do not mix.? That’s the conundrum of the value proposition for TSCM.

That said, Cramer does use price momentum as one of the factors in his stock selections.? He is generally a “trend follower.”? Cramer also is not a value investor.? Much as I appreciate him giving me a chance to write, we aren’t very similar.? That’s consistent with TSCM philosophy — they want a large range of views.? I wrote there for four years, and was one of their leading writers.? I rarely interacted directly with Cramer, instead, putting forth my own views, which did better (in my opinion).

I’m not Cramer, and he’s not me.? He just gave me a chance to write, for which many are grateful.? (I would tell you that he taught me how to trade corporate bonds, even though he has never traded corporates, but that would be a long story.)

Pressing on

This is not my last article on this topic.? I intend on continuing this discussion, to flesh out where I agree with Mr. Covel, because at many points I do agree, but there are complexities that need further elucidation.

The main areas I will cover in the future include:

When does trend following fail?
What other factors should we consider?
What constitutes adequate proof that a strategy is superior?

I credit Michael Covel for commenting at my blog, and I will answer his question, but not today.? It is a valid question, but there are other questions that can be posed to him as well.? Let the debate commence on a fair basis.

Book Review: Trend Following

Posted on 25 April 2009 by David Merkel

This review is unlikely to make me friends, and likely to generate some negative mail.? Let me start with the conclusion: don’t buy the book.? That said, my reasons for stating this are different from those who typically criticize Michael Covel.? I agree with much of what he says; I disagree with much of his rhetoric.? Let me give you my thoughts:

1) Momentum is a pervasive factor in the markets.? It works about 80% of the time and produces significant excess returns on average.? Behavioral finance points out that people are slow to adapt to new information, so momentum tends to work because the initial moves on new information aren’t sufficient.? That said, when too many are chasing momentum, the market becomes extremely volatile, and the strategy ceases to work, until it shakes out enough momentum-followers.

What is hard, is distinguishing trend following from technical analysis from momentum.? Personally, I think momentum explains the other two.? It’s a much simpler theory, and much as Covel appeals to Occam’s Razor, I apply it back to him here.

2) He draws on a series of investors that have done well in the past, and touts them as proof of his theories.? Hindsight is 20/20.? What of those that have tried to apply trend following and failed?? Is it many or few?? Keeping a tight stop loss for some means the death of a thousand cuts.? The studies that I have seen show that frequency of trading tends to decrease returns.? Now, trend following does not necessarily mean a lot of trading, but for many it ends up being that way.

It is easy to locate a bunch of trend followers in hindsight, and tout their abilities.? What would be harder would be to find the whole universe of people following trends, and see how they do as a whole.

3) Mean reversion is a weaker factor, but still significant in making money.? Value investors typically do well with it, but only reliably when they insist on strong balance sheets.? I’ve studied mean reversion for years, and it exists in almost all markets as a weak factor.? Over enough time, that weak factor has punch, but in the short run, momentum rules on average.

4) Covel spends a lot of time trashing fundamental analysis, without much meat behind it.? Fundamental analysis works well, but doesn’t have so much value because so many are applying it.? It’s not like the situation Ben Graham found, where few were doing it.

Aside from that, technicians implicitly rely on fundamental analysis, because their support and resistance levels stem from the decisions of fundamental investors.? Same for those that follow trends.? The trends exist because fundamental investors react slowly to changes in the fundamentals, and trend followers exploit them.

5) There is no mention of the Adaptive Markets Hypothesis, and little discussion of Behavioral Finance.? These are much richer theories that encompass “trend following.”

6) Covel takes “pot shots” at Buffett over issues that are unrelated to his main point in an effort to discredit him.? Buffett is a bright guy who can criticize derivatives in aggregate, while still using them in specific to his advantage.? (Cough, cough.? Please ignore his put option trades.)

7) There was not enough time spent on “how to trend follow.”? After reading the book, if I didn’t have prior background knowledge, I would be scratching my head to figure out how I could reliably pick investments in a trend following mode in order to make significant excess profits, as well as know where to sell them.

I don’t recommend it, but you can buy it here: Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets

Final note — Covel needs to grow up and learn that there are other factors in the market aside from momentum.? He has become a fundamentalist about “trend following” and does not seem to have the open mind that he harps about.

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? Such a deal if you wanted to get it anyway?