Making the case for simply following the trend

Sticking with your winners, even the overvalued ones, appears to be the best strategy. From Moneyweb.

A survey of six major brokers reveals a stark reality: 71-80% of their clients lose money. Nearly 80% of those using quantitative strategies face losses, and among active day traders, up to 95% lose money.

These are the frightful realities that face any investor looking for an edge in the market.

“Clearly, investors need a more disciplined, strategic approach to managing their portfolios. Trend following could be the best strategy to fit the bill,” says Alex Krainer in his book, Trend Following Bible.

“After more than 25 years as a market analyst, researcher, trader and hedge fund manager, I have few certainties about investing apart from these two:

• “That market trends are the most powerful drivers of investment performance;
• “That trend following is by far the most profitable strategy of long-term investing.”

It’s interesting to note that the one group of investors with astonishing predictive powers is US senators, who outperformed equity markets by 12 percentage points a year over eight years, as measured by Georgia State University researcher Alan Ziobrowski.

That performance was better even than corporate insiders, who beat the markets by 5%, while ordinary investors underperformed by 1.4%.

What insights, wondered Ziobrowski, did US senators possess that gifted them such extraordinary investment success?

It’s long known that a stint in US politics is a speedway to the millionaire class, given its privileged access to insider information.

Market consensus is not always right

Those who do not have inside market information must rely on analysts and ‘market consensus’.

But there are many instances of market consensus getting it dead wrong. The 1990s oil price collapse to around $10 a barrel is a case in point: there was a growing belief that the world was facing a ‘peak oil’ crisis when demand would far outstrip supply. The global economy was in full-throated roar, and investment was being fire-hosed into telecoms and IT rather than new oil production. Analysts at the time saw it as inevitable that demand for oil would explode, pushing prices higher. Instead, oil prices more than halved between 1997 and 1998.

Analysts believed the market had simply got it wrong about oil or was being manipulated. Here was a case of a trend continuing more powerfully and for longer than common sense would dictate.

Read: From boring to billionaire …?

Bitcoin – the best-performing asset of the last decade – is another example of a trend that seemed to defy all expectations. The same applies to the S&P 500, Nasdaq, and the shares of companies like Amazon, Apple, Alphabet, Tesla and Microsoft.

Trend following – or the study of charts – means discarding the fundamental narratives believed to drive price action, argues Krainer. Trying to fight these trends is futile and likely to result in loss. Part of the reason for this is the bias baked into analysts’ narratives, which rely on the energy industry, investment bank reports, or government agencies, all of which tend towards exuberance. Add to this the frequently alarmist research coming out of academic institutions, framed by ideological objections to fossil fuels or nuclear energy.

The investor has to wade through this miasma of potential disinformation.

“The arithmetic of government statistics – jobs, growth and inflation – is distorted and dishonest almost beyond measure,” said fund manager Paul Singer.

Research teams produce professional and credible-looking reports with neatly tabulated figures and compelling-looking charts, says Krainer, but they often lead to rather different conclusions. “Between the lines, it is not difficult to discern the root of each group’s bias. The oil industry and their bankers want to attract investment capital.”

The folly of forecasting

Forecasting is another folly that tends towards groupthink, with the best economists in the world completely blindsided by the economic slumps of the early 2000s and the follow-up financial crisis of 2008-9, as shown by the US Federal Reserve Bank of Philadelphia’s Livingston Survey (which comes out twice a year).

Virtually no one saw any iceberg ahead when making their growth forecasts in these crucial years.

Oil price forecasts have likewise been all over the place, as the US dollar strength was shown over the past several decades to have had the strongest influence on the commodity price – not supply and demand fundamentals.

Market forecasting is about as useful as tossing a coin. A study by the CXO Advisory Group examined more than 6 500 stock market forecasts from 2005 to 2012 made by 68 experts – and found that just 46.9% were accurate. As computerised forecasting models have become more complex and require greater numbers of data inputs, small variances in any one of the inputs can result in large differences in the final results.

SA has a long and sordid history of fanciful economic forecasts, with 80% of National Treasury forecasts of economic growth for budgetary purposes falling short of the mark.

Read: A decade of budgetary whoppers

For the past century, stock markets have mainly trended upward, with occasional crashes and corrections. This made it possible for investors to generate positive returns, even if investing passively.

Decades of research led to the conclusion that expertise in the form of active fund managers, armed with degrees and volumes of data, is unable to consistently beat the market.

This has been confirmed in several studies. One such study by investment advisory firm Daniels and Alldredge found that only 9% of 658 global equity funds beat the QGS index, with the performance span ranging from 14% below the index to 6% above. In other words, there is a much higher likelihood of poor performance and a limited chance of outperformance.

One of the great underreported skeletons of fund management is the huge cost of developing quantitative systems that don’t work.

A case in point is the 1998 collapse of hedge fund LTCM, led by Nobel laureates Robert Merton and Myron Scholes.

Another is the 2012 wipeout of $440 million at Knight Capital in just 30 minutes due to a faulty trading algorithm. To be fair, there are algorithms that perform as expected, but success has often come at a huge cost.

News is the enemy

Star traders like George Soros acolyte Victor Niederhoffer, who adorned the covers of business magazines before he got wiped out in the 1997 stock market crash, are a rarity. Warren Buffett, much as he might resist the label, is a momentum investor.

There is a tendency for traders to immerse themselves in news that either supports their trading decisions or injects doubt into them.

An interesting study by Paul Andreassen at the Massachusetts Institute of Technology divided students into two groups.

Each was free to buy and sell stocks as they saw fit, but one group had constant access to market news, while the other group was restricted to monitoring their portfolio performance only through changes in stock prices. The experiment showed that students who got no financial news at all earned double the returns of those who frequently checked the news. The lesson here appears to be that news is the enemy of good investing.

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