The Trend Following Mantra: Fundamentals Are Religion

There are two basic market theories. The fundamentalist studies economic realities—supply and demand factors—that they believe underlie market values. Fundamental analysis relies on government policy, economic projections, price-earnings ratios, and balance sheet analysis (and so on) to make buy and sell decisions. The religion of fundamental analysis is about telling stories:

• Crude oil traded near an eight-week low because of concern fuel demand will be curbed amid signs of slowing economic growth in the U.S. and the U.K.
• History suggests the time is right to buy Dow stocks.
• It’s not too late to profit from rally as market’s cycle shifts in favor of blue-chip stocks.
• They’re cheap by recent historical standards.
• The index’s trailing price to earnings ratio, a measure that shows investors how much they are paying for a dollar in earnings, is well below what it has averaged.
• The price to earnings ratio for the S&P 500.
• Commodities look to be more expensive in the coming sessions and coming weeks to months.
• Has the metals correction run its course?
• My gut tells me the indices are overdue for a setback but the jury is still out.
• Secular decline over the last four cycles.
• We feel an interim top is in.
• Decline in nominal GDP.
• Based on supply and demand constraints, corn and soybeans need to trade higher to ration demand and to find more acreage.
• Initial unemployment claims.
• Is this just a correction or could it turn into something more serious?
• Political and social unrest in the Middle East.
• Big miss in headline payrolls.
• Key driver of seasonal demand patterns in gold.
• A bullish USDA report aided in corn appreciation.
• Rising energy and materials shares, spurred by surging oil and gold prices, have kept stocks in positive territory.
• The FOMC is meeting today and tomorrow so stay alert as even inaction can be a market mover.

The fundamentals never stop. So do you buy or sell oil now? Exactly. Who knows how to really trade with fundamentals? Very few, if any, know how to use them. This is not new. People have told stories for centuries. It is an activity that calms and soothes.

Think about religions. Many were created to satiate a desire for order. Investors are no different. They want “cause and effect” explanations and feel security in the illusion that there is a deeper understanding. It does not matter if the moneymaking strategy works or not. All that matters is the story. Sheep go to slaughter much easier when they’re comforted and showered with sweet nothings.

So how can the religion of fundamental analysis, taught on every college campus and practiced at every mutual fund, generate repeatable alpha? It cannot.

Example. One famed financial web site pointed to chocolate pudding in their bio. When they were young, they learned about stocks from their father at the supermarket. He would say, “See that pudding? We own the company that makes it. Every time someone buys that pudding, it’s good for our company. So go get some more.”

That story might be cute, but it is childlike ideology. Krispy Kreme makes great donuts (no doubt), but it’s stock is around $6 years after reaching a high of more than $40 a share. The “story” is irrelevant.

However, even the so-called educated don’t see clearly. A billion dollar fund invited me to talk. They wanted to invest money into trend following but were having a hard time accepting that it was not rooted in fundamentals. They were comfortable with a trader who knew one market alone—fundamentally. They worshiped the idea that a trader could know everything about some one market, which would supposedly translate to profit. They could not grasp trend following.

It does not matter if you’re trading stocks or soybeans. Trading is trading, and the name of the game is to make money, not get an A in “How to Read a Balance Sheet.”

Technical analysis, the other market theory, operates in stark contrast. It is based on the belief that at any given point in time, market prices reflect all known fundamentals for that particular market. Instead of trying to evaluate fundamental factors, technical analysis looks at market prices themselves.

There are essentially two forms of technical analysis. The first is based on reading charts and using indicators to supposedly predict market direction. For example, here is a mixing of fundamentals and predictive technical analysis:

Grains all made subtle bull breakout technical moves last week as continued fear of a global grain panic builds premium into these markets. I do believe that the grain rally should be sold into as it will be short-lived in 2011. The market is in the “what-if” stage of the winter season as they get ready for plantings. What if China needs to import corn? What if Australia’s wheat crop is gone? What if cotton acreage squeezes beans? Well how about what if the market meets demand? I do not expect grain prices to test 2008 levels—the fundamentals are not there yet and the hype isn’t strong enough. Soybeans are a good spread play against corn, but overall I would be a put buyer across the board. Rice is a sell into this short covering rally with straight puts.

That is a view of technical analysis held by many. It’s worthless. Run when you see that kind of talk.

Yet, there is another type of technical analysis that does not try to predict. Trend followers are the traders who use reactive technical analysis. They react to market movements and follow along—without a story.

That’s trend following. It’s why the Turtles have made fortunes.

Blowing Bubbles Leaves Great Market Opportunity

“People are shortsighted, overconfident in so-called predictive skills, and irrationally prone to buying insurance on cheap home appliances. In short, they exhibit tendencies not unlike your not so swift brother-in-law.”

“The human brain responds to high-stakes trading just as it does to the lure of sex. And the riskier trades get, the more the brain craves them.”

“Social conformity drives human beings. Even if the group is wrong, people go along.”

Sounds about right, right? Consider the question: Does raw human emotion dictate financial decisions, or are we rational calculators of our self-interest?

The idea that we behave irrationally when it comes to money may not seem radical, but it challenges the dominant University of Chicago economic philosophy that has framed business and government for fifty years. Their campus has given rise to more Nobel Prize winners in economics than any other institution. Nearly all share the common assumption:

When it comes to money, we are highly rational.

One of the foremost champions of that view is Gary Becker:

“The most powerful theory we have, and I think it’s the most powerful theory in the social sciences, is economics as a theory of rational behavior at an individual level, and that’s the theory we rely on.”

Other academics are not on board for obvious reasons:

“The 2008 crash really matters because much of the behavior that led up to the crash is unexplained by the discipline of economics.”

More Chicago academics ignore the 2008 crash:

“I’m sorry, that’s such an empty argument. That’s just an insult, a pointless insult.”

Eugene Fama, the father of so-called efficient markets, smirked:

“I don’t see this as a failure of economics, but we need a whipping boy, and economists have always been whipping boys, so they’re used to it. It’s fine.”

Those economists defend their view no matter what. People and markets are rational? Small children now know that is not true. However, university professors have convinced themselves human beings only use robotlike logic. On the other hand, Jeremy Grantham has made money for 40 years by finding price bubbles and betting against them:

“We’ve found 27 bubbles. It’s euphoria causing the price to go up and realism causing it to fall back, and then, eventually, unrealistic panic, as it begins to feed on itself, and the lemmings head in the opposite direction.”

One academic does see it like Grantham. Nobel Prize winner Vernon Smith devised an experimental market in which investors could create a financial “bubble.” Far from learning from their experience after creating a bubble, investors would go on to create yet another bubble. This time, the bubble occurred earlier than the prior experiment and was not as pronounced as the first. When investors were asked why they allowed themselves to create a second bubble, the most common response was they thought they could get out before the top this time. Smith’s research showed that the only reliable method of removing bubbles is to use players who are experienced twice over. We apparently only learn after two blowups!

Give Rod Serling credit for figuring it all out back in 1960, and give him more credit for burying it so elusively in an episode of The Twilight Zone:

Alien visitor #1: Understand the procedure now? Just stop a few of their machines and radios and telephones and lawn mowers… throw them into darkness for a few hours, and then just sit back and watch the pattern.

Alien visitor #2: And this pattern is always the same?

Alien visitor #1: With few variations. They pick the most dangerous enemy they can find and it’s… themselves. All we need to do is sit back… and watch.

Popular delusions are a foundation of trend following profit.

“100-year floods actually happen far more frequently. Since 1929 there have been 18 market crashes.”