Saturday, 5 February 2011

The fundamentalist trend-follower's bible

What kind of cynical marketer calls a book "Trend Following - Learn how to make millions in up or down markets"?  There's even a helpful tagline: "The strategy that made millions in the 2008 Market Crash" (their emphasis).  Michael W. Covel, apparently.  I'll make a number of generous assumptions and follow through their consequences.  First, let's assume that the strategy of trend following which materially is the subject matter of his book can, either through individual endeavour, or through investing in the right trend following investment manager, produce annualised returns of 100%.

Second, let us focus on 2008, as the tagline invites us to do.  If a strategy made millions, let us conservatively assume it to be two million (USD assumed) that year.  So, we have a strategy which we generously allocated 100% returns to, and which made a two million dollars in profit.  In order for that to have happened, the adventurous reader must have risked two million dollars of their own money.  Yet clearly this cynical marketing ploy isn't aimed at the world of high net worth investors, but the interested investing public.  They will not have anywhere near two million dollars to invest, so the disingenuous exhortation is mostly exploitative hyperbolic marketing. Assumed daily compounding would bring the initial deposit required down somewhat, but you get the point I hope.

Finally, the book spends some time justifying, contextualising and exonerating the reality of large draw downs in the records of that set of trend followers which Covel has been able to cosy up to.  He claims that achieved return itself rather than volatility adjusted returns (Sharpe ratio) are a more appropriate measure for trend following funds.  Leaving aside the fact that I think this is a dangerous selection to be promulgating to the investing public, even on its own terms it argues against having such a deceptive "made millions in 2008" tagline on the front cover - for even if his argument is right that one shouldn't look at one big losing percent return in any one year, surely to avoid the accusation of self-interested inconsistency, he should not pick any one year of positive returns and booster them so shamelessly. 

I decided to buy this book and read it.  My conclusion is Covel is a fundamentalist trend-follower.  The phrase sounds like an oxymoron, since so often trend-following is pitched against a fundamentals based approach to investing (whether that be analysis of commodity supply and demand effects, analysis of the capital structure and balance sheet of firms or macroeconomic  analysis).  By fundamentalism I mean a kind of quasi-religious blind faith in an approach which accompanies an almost evangelical re-description of investment reality in terms of them and us.  Them being anyone who thinks they can make investment or trading decisions that use a valuation model based on anything other than price action.  Us being those who rely on price action only.

You'll find in this book a kind of anti-intellectualism shared by many blind-faith religious people.  Historically, the branch of finance which tried to bring intellectual rigour to the examination of market prices arguably started with Bachelier in 1900.  To be sure, before this was a series of practices and assumptions aimed at applying rules of thumb to trading. Examining only price action (including volume and open interest, where appropriate) is clearly a kind of primitive attempt.  The analogy I think of is in trying to explain the movement of oceanic water.  Examining nothing other that the surface phenomena of price action is analogous to looking at surface wave movements only - where the wind explains some part of the movement.  Now what might really be moving bodies of water requires a fundamental model - for example, how gravity, the moon, ocean floor structure, temperature might explain the movement of oceanic water mass.  This isn't to say that the wind explanation is subsequently wrong, rather it is incomplete.  It is an open question whether finance is at a stage where the fundamental models hold up well to our reality - for example the efficient markets hypothesis (EMH), which largely looks to debunk some of the 'price action' approaches, has come in for some recent well aimed criticism.

It could be argued that the EMH tried to sweep away many theories of price action with a single factor (beta, in the pure formulation) or multiple factors (in the later Fama French formulation).  Set against the academic position is some evidence of consistent, long-lasting out-performance of some price action funds (in particular, that subset which relies on so-called momentum effects - the eponymous trend followers of the Covel book).

Rather than impartially presenting the evidence, Covel instead, like any good evangelical sectarian blind-faither, pitches the story as one of competition between two mutually incompatible doctrines.  He, and a fair few trend following investment managers, make a virtue of the 'know nothing' approach they espouse (you could call the approach 'phenomenological' instead if the spirit of charity overwhelmed you).  They mock the fundamentals failures and lay claim to be the direct beneficiaries of the many failures of fundamentals based investing.  None of this is necessary.  Both approaches can coexist, and perhaps should.  He does a great disservice to the science behind the momentum effect with his empty rhetoric.  To borrow a term from Comte's classification of the stages of science, he's degraded the science of the momentum effect into a kind of metaphysics.


  1. I found this content on

    daniel Says:
    February 8th, 2011 at 5:27 am
    Big misstep. Who cares why oceanic water is moving; it’s moving!

    I SAY: Daniel, people who care care.

    Todd Miller Says:
    February 8th, 2011 at 8:02 am
    “…where the wind explains some part of the movement”. Who cares that the wind plays some part? Who cares what plays the other part? All we know is, it’s moving.
    Some will never get it.

    I SAY: People who care care.

    Alexander Says:
    February 8th, 2011 at 9:41 am
    Instead of going on a long-winded pseudo-scientific rant, why didn’t the good chap, Ellsworth, post his track record?

    I SAY: The original reviewer of my review tagged me as a crypto-socialist. Yes, REALLY.

    Michael Covel Says:
    February 8th, 2011 at 10:50 am
    I wonder how accepting pro trend following track records, along with all of the other supporting pieces of evidence that back those, was blind faith?

    I SAY: Michael the blind faith is with respect to making a virtue of the 'know nothing' approach to the relationship between finance fundamentals and trading. I have no difficulty in accepting good trend followers' records. I believe all those tables in your book.

    Gary Says:
    February 8th, 2011 at 2:27 pm
    I know why he didn’t like it Michael. You didn’t use enough big words!

    I SAY: I think there's a lot of this anti-intellectual attitude going on in trend following.

    Jaytrader Says:
    February 8th, 2011 at 2:47 pm
    Those who can, trade.
    Those who can’t, criticize.

    I SAY: The original quote from HL Mencken
    ( was : "Those who can do, those who can't teach". But I guess Jaytrader you're OK with Michael Covel, teacher? ;)

    Jeff Waters Says:
    February 8th, 2011 at 6:23 pm
    “Rather than impartially presenting the evidence, Covel instead, like any good evangelical sectarian blind-faither, pitches the story as one of competition between two mutually incompatible doctrines.”
    This is a fair comment IMHO.
    Trend following works. But surely whilst it’s a truth, it’s not the only truth. For example, there are fundamental traders who make a good return year after year. OK, many fundamental traders also lose money consistently, but any approach is only as effective as its exponents are skillful and disciplined. As as was recently pointed out in reader comments in this blog, some trend followers combine trend following with other techniques.

    I SAY: Agreed.

    Michael Tatman Says:
    February 9th, 2011 at 10:06 pm
    He might consider reading the book more than once. That assumes he did more than just scan it to begin with. I find it hard to understand why he said there is no evidence, when in fact, the numbers speak for themselves.

    I SAY: I find it hard to understand why you think I said there's no evidence for trend following - I suggest you re-read the article.

    Andre Says:
    February 11th, 2011 at 3:12 am
    “Yet clearly this cynical marketing ploy isn’t aimed at the world of high net worth investors, but the interested investing public. They will not have anywhere near two million dollars to invest, so the disingenuous exhortation is mostly exploitative hyperbolic marketing. Assumed daily compounding would bring the initial deposit required down somewhat, but you get the point I hope. ” Well I believe that he doesn’t know that nowadays one can be “exploited” :) with 50 bucks byuing a share of the AQR Managed Futures, right? Or wait, how about investing with these guys Covel says? Doesnt take 2million. Dont waste ur talent with this Ellsworth, he’s not acutally “worth” anything

    I SAY: Nothing.

  2. Joe Harman Says:
    February 12th, 2011 at 10:10 am
    My first post to Michael Covel’s website: Ellsworth Toohey would have us believe that oceanic water movement can somehow be predicted if all the underlying fundamentals are known. I suppose he predicted the 2004 Indian Ocean tsunami.

    I SAY: Joe you suppose wrong. What I said was " It is an open question whether finance is at a stage where the fundamental models hold up well to our reality"; What you heard was "I know so much about finance/the ocean that I can even predict one off crises". How utterly off the mark can one man's supposition be.

  3. In the spirit of light heartedness I thought I’d rewrite my review especially for Gary and Alexander, who didn't like the style.

    From A Fellow Surfer who loves other sports too.

    Dude, your book’s cover overly sucks. You gotta eat your own shit on drawdowns and lay off over-selling your own gang’s 'holy grail' at the expense of everybody else’s. You gotta know that people really are making money in the markets using good shit that ain’t just price action. You gotta know there really is another side or three to this stuff other than prize-winning surfing. You and I should keep on surfin’ and collectin' the prizes by all means but please quit tryin’ to turn other people off to the other wonders of the ocean. Maybe some days somebody real smart might invent an even cooler way of having fun while gettin’ rich from the ocean, but not if they swallow your medicine.

  4. Trend Following, p112 contains a discussion of the relative merits of 'covariance' versus 'standard deviation'. The author says "Unlike misguided comparisons, such as standard deviation, I find correlation comparisons of performance data useful'.

    In fact correlation is defined in terms of variance (or standard deviation, which is its square root). They're both part of exactly the same branch of statistics which brought us portfolio theory, CAPM, rational expectations, the efficient markets hypothesis.

    The lesson of portfolio theory is : it's good to diversify. So that's why it is baffling why the author then proceeds to use correlation to point out exactly how similar all these trend following strategies are. It certainly tells us nothing about their diversification value per se - to do that, may I suggest you compare trend following variances with non-trend following approaches; it tells us nothing about the absolute performance of winning trend followers - imagine they all failed regularly in the same way, then they would have high correlations too, so that isn't actually telling you anything other than the winners herd like cattle rather than develop individualistic Ayn Rand-approving strategies.

    Saying baldly that you don't like variance in performance attribution but you do like covariance is a pretty dumb thing to say. Let me translate. "I think variance doesn't work for single variable analysis but it does work for multi-variate analysis". I just don't think the author gets it. Further evidence he doesn't appears on that same page 112, where he purports to explain the reason why winning trend followers act more like cattle (or lemmings) than individuals is "...because they can respond only to what the market offers". Utter nonsense as a 'because'. Fundamentals based trading likewise can respond only to what the market offers too; and anyway, this is not the CAUSE of the correlation in any way, shape or form. The CAUSE is the herding behaviour.

    The book is full of such examples. I spent a penful of ink scribbling on my copy.

  5. The original reference to my review was on by Mr Covel himself. Before quoting my review in full he says:

    "Spotted the following review. It appears written by an Ellsworth Toohey doppelganger. That said, if you are sitting on the fence, or trying to better understand trend following, these types of reviews are very educational. The issue for you: what education will you take from it?"

    He finishes with a short

    "Once past the ad hominems, the section set out in ‘blue’ — is this chap’s massive misstep. That is the take away."

    The section in blue to which he refers is my ocean metaphor. I think it is a decent mataphor, and surely no worse and not significantly different from the "bucking bronco" metaphor he quotes admiringly on his own front page.

    The best snake-oil salesmen have always had an incentive to deal head on aggressively with 'the opposition' and to pump their message at the expense of the medicine buyers.

    I'm amused at his ad alius hominem response to my alleged ad hominem. The Ellsworth Toohey character from the Fountainhead - one of the great popular works of libertarian individualism for Americans by a Russian seems to me to be intellectually a characterisation of none other than the early sociologists - Comte and Quetlet in particular. Given I've dedicated so much of my recent blog posting to showing how Comte was a cyrpto-fascist, I find that too quite informative that Covel should attach the label to me.

  6. I cleaned up the two typos Michael Covel spotted in my original article - thanks. I'm returning the favour:

    (1) p116 Robert Samuelson is not a "noted finance professor" but a Washington Post journalist. Here's his biog straight from the Washington Post

    "Robert J. Samuelson is a weekly columnist for The Post, writing on political, economic and social issues. His column appears on Wednesdays.
    Samuelson joined The Post on the business desk in 1969. In 1976 he became an economic reporter for National Journal, where he began a weekly column, which began appearing in The Post in 1977. In 1984, Samuelson became a columnist for Newsweek. Samuelson's awards include the National Headliner Award for Consistently Outstanding Column on One Subject in 1995, 1993, 1992 and 1987; a 1993 John Hancock Award for Best Business and Financial Columnist; The Gerald Loeb Award for Best Commentary in 1993, 1986 and 1983; a Clarion Award for Best Magazine Editorial/Opinion Column from Women in Communications in 1994; and a 1981 National Magazine Award.

    He is the author of "Untruth: Why the Conventional Wisdom is (Almost Always) Wrong" (2001), a collection of his columns, and "The Good Life and Its Discontents: The American Dream in the Age of Entitlement, 1945-1995" (1995)."

    Perhaps you were thinking of Paul Samuelson, one of the great minds of 20th Century finance?

    (2) On p13 you inadvertently label the chart as displaying NASDAQ figures - there aren't in fact any NASDAQ figures there.



    Several months later Covel replicates the religious metaphor I developed here into another, seemingly even more empty book - judging by the initial comments on Amazon.