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.