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.
• EBITDA.

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.

Speculari

The film director Oliver Stone believes that speculation is evil. That’s interesting. He has written some fantastic scripts. He has directed Oscar-winning films. Nevertheless, to say that speculation is “the mother of all evil” is disingenuous. When Stone sets forward to make a new film, he’s speculating that you will spend your money and watch his film. There is nothing wrong with that. That’s life. That’s a good thing.

Speculation in markets is essential too. Think about what drives a market. It is millions of people speculating to make money. One of the most successful trend following traders knows deep down how important speculation is to finding opportunity:

“Speculari, the Latin root of the verb “to speculate” has the literal meaning to observe. To be successful this observation must, of necessity, be detached and unemotive and thus where great social and moral issues are at stake, it is perhaps not surprising that distrust and hostility among the general population can arise particularly when the speculator profits at a time of general discontent. Yet this detached observation is clearly in the spirit of the natural scientist and the act of speculating for money is in the spirit of the empirical scientist’s restless yearning to add to empirical knowledge and put theories to the test.”

Regardless of whether you win or lose, you are speculating—trying to get ahead. Every time you get into a car, you are speculating. If you go to the Apple store to buy an iPhone you are speculating the phone is more valuable than your dollars. Additionally, you are speculating the iPhone will work. When you turn on a show you are speculating that it is worth more than something else. All of these activities don’t always work out, and that is the nature of speculation. All speculators are not winners.

So why is it bad to take advantage of an opportunity that you recognize? It’s not.

Speculate this: Do you consider yourself an investor or a trader? Investors put their money into investments hoping value will increase over time. Typically, they have no plan if it goes down. They usually hold on, praying value will reverse and go back up. Investors typically succeed in bull markets and lose in bear markets. They usually have no coherent response when the losing starts. They often hang tight and continue to lose even more.

Traders are different. They have a defined strategy to put money to work for a single goal: profit. Wise trend traders do not care what they buy or sell as long as they end up with more money in the long run. Bottom line, winning traders don’t invest, they trade. It is a massive distinction.

Consider timeless qualities essential to speculation:

1. Self-reliance: A man must think for himself and must follow his own convictions. Self-trust is the foundation of successful effort.

2. Judgment: That equipoise, that nice adjustment of the faculties of one to the other, which is called good judgment–essential to the speculator.

3. Courage: That is, confidence to act on the decisions of the mind. In speculation, there is value in the dictum: Be bold, still be bold; always be bold.

4. Prudence: The power of measuring the danger, together with a certain alertness and watchfulness, is very important. There should be a balance of prudence and courage; prudence in contemplation, courage in execution.

5. Pliability: The ability to change an opinion, the power of revision. He who observes and observes again is always formidable.

I don’t care whether you ever trade, but those precepts should be the first life lessons taught to grade school kids.

“The most valuable commodity I know of is information, wouldn’t you agree?”
–Wall Street: Money Never Sleeps