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Practitioner Viewpoint: Michael Covel reviews the lessons of 2008.

Tuesday, April 07, 2009


Following the Winners

The first edition of Michael Covel's Trend Following: Learn to Make Millions in Up or Down Markets came out in 2004. It offered useful insights as to how successful futures traders make money. Mr. Covel has written an updated edition that contains even more useful information and insight. Below are excerpts from the new edition, published February 2009 and available from FT Press.

The world changed in October 2008. Stock markets crashed.. Millions of people lost trillions of dollars when their long-held buy and hold strategies imploded. The Dow, Nasdaq and S&P fell like stones, with the carnage carrying over to November 2008. Most everyone has felt the ramifications: jobs lost, firms going under and fear all around. No one made money during this time. Everyone lost. Hold on, is that really true? It is not true.

Wall Street is famous for corporate collapses or mutual fund and hedge fund blow-ups that transfer capital from winners to losers and back again. However, interestingly, the winners always seem to be missing from the after-the-fact analysis of the mainstream media. The press is fascinated with losers. Taking their lead from the press, the public also gets caught up in the drama and narrative of the losers, oblivious to the real story: Who are the winners and why?

The performance histories of trend followers during the 2008 market crash, 2000-2002 stock market bubble collapse, the 1998 Long-Term Capital Management crisis, the Asian contagion, the Barings Bank bust in 1995, and the German firm Metallgesellschaft's collapse in 1993, answer that all important question: “Who Won?”

There were winners during October 2008 and they made fortunes ranging from 5% to 40% in that single month. Who were the winners? Trend followers. How did they do it?

First, let me state how they did not do it:

1. Trend followers did not know stock markets would crash in October 2008.
2. Trend followers did not make all of their money from shorting stocks in October 2008.

What did they do? Trend followers made money from many different markets from oil to bonds to currencies to stocks to commodities. Trend followers always seem to do particularly well in times of wild and extended price swings, in part because their trend following trading systems programmed into computers can make calculated, emotionless buys and sells that human traders might be slower to accept.

The market crash of 2008 offered fantastic data to see how trend following is so different from most of the investing world's mindset.

Logically, it is difficult to keep saying trend following is risky, especially in the face of “leveraged buy and hold” approaches that cratered in 2008, but then again who said most of Wall Street (what's left of it) is logical. I have these same conversations with many top trend followers. I sometimes think they scratch their heads that so many people don't take advantage of what they offer.

Maybe 2008 will be the tipping point for acceptance, but I would not bet on it!

Batting Average

The period from 2000-2002 was littered with volatile up-and-down markets. Although the prime story for that three-year period was the Nasdaq meltdown, several subplots also existed ranging from September 11 to Enron to trend following drawdowns and subsequent recoveries to new heights.

(For most of 2000) trend followers were in a nasty drawdown. They were down significantly heading into the last few months of the year. The press and skeptics were calling the strategy finished. … (But) the tide was turning.

People place too much emphasis on the short-term performance of trend followers. They draw conclusions about one month's performance and forget to look at the long-term. Just like a batting average, which can have short-term streaks over the course of a season, trend followers have streaks. Trend following performance does deviate from averages, but over time there is remarkable consistency.

One of the main reasons that trend following trading does well is because it has no quarterly performance constraints. It is opportunistic. What do I mean? Both Wall Street and Main Street measure success on the artificial constraints of the calendar. For example, looking back at the end of 2000, you see that without November and December offering such huge home runs, trend followers would have had a terrible year. For those people who judge trading success by “quarters,” trend followers were dead the better part of 2000.

The whole idea of quarterly performance reporting implies you can predict the market or successfully shoot for profit targets. Quarters as a measurement might not be real, but they provide a comfortable structure for investors who mistakenly believe they can demand nice, consistent profits.

Imagine playing football where there are four quarters and you have to score in each quarter to win. If a trend follower scores 28 points in the first quarter and no points in the next three quarters and wins, who cares when he scored? Wall Street's misguided emphasis on quarterly performance puts more importance on scoring each quarter than it does on winning the game.

The alternative is to become a home run hitter and take what the market gives no matter when it arrives.

Critical Thinking

Trend followers, like physicists, approach their world with an open mind. They examine and experiment. Like physicists, they think critically and ask smart questions. The skill of asking objective and focused questions (and then finding the answers) is a key reason why trend followers excel. To be successful as a trader, to be successful in life, you need to develop an ability to ask those right questions, those smart questions.

Unfortunately most people do not ask critical questions when it comes to money and markets. Bernard Madoff is the great example…. The questions they do ask tend to be superficial and ill-informed because they have not taken ownership of the issue. Instead they ask dead-end questions (along the lines of) “Is this going to be on the test?”

I hope investors who have asked few questions so far and, as a result, been beaten down by their rote memorization of the mantra “buy-and-hold is good for you” will finally ask critical questions and scientifically examine data for themselves.

Act as a devil's advocate. Question assumptions. Check your inferences. Consider the improbable or the unpopular.



 
This article was published in Opalesque Futures Intelligence.
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