Book Review: Trend Following (3)

What I find interesting about this subject, whether we call it “trend following” or “price momentum,” there has been a confluence of different parties agreeing that price momentum works.  I have reviewed many books recommending momentum strategies (an example), and have usually recommended them (sometimes with reservations).  I will even recommend Trend Following to those who don’t know that positive price momentum aids investment performance about 80% of the time.

What groups of people have come in to support price momentum?

  • Most quantitative stock screeners/graders use a mix of momentum and valuation factors.
  • The academics behind behavioral finance support price momentum and valuation factors, in addition to some others.
  • Many large (and smaller) hedge funds that trade stocks do so using momentum as a positive factor in stock selection, along with valuation, earnings quality, and a host of other factors.

I know, there are still Efficient Markets Hypothesis zealots in the academic community, but they are being outflanked by the behavioral economists who have hard data to support their theories.  The Adaptive Markets Hypothesis describes the way the markets really work.  Rather than using a physics-based analogy, better to use a biological analogy — I view investment strategies through an ecological frame.  Multiple strategies compete to obtain scarce excess investment returns.  The strategies that are least pursued relative to their validity usually have the greatest punch.

Is everyone a fundamentalist?  Momentum strategies win.  Are there a lot of traders chasing momentum?  Value strategies win.  Is there a dominant view to seek dividends?  Growth strategies win.  Is everyone chasing after growth?  Perhaps we should look for dividends.

I don’t know about everyone, but among quantitative investors the opinion is virtually universal that trend following is the right strategy.  Follow price and earnings momentum.  I even put out a small piece weekly on short-term performance of industry groups, which is largely based off of price momentum.

So, if Mr. Covel thinks that trend following is an underfollowed idea, I can simply say that there are a lot of us following it, to the point where the trade might be crowded.  Trend following is a significant part of the total market ecology, and when it becomes dominant, its short-term returns become curtailed, until enough money leaves the trade.

I’ll discuss this more tomorrow, when I discuss how we test the validity of investment strategies.