Consider this excerpt from Mark Croskery, a wealth manager at NCB Capital Markets Limited.:

Benjamin Graham, who believed in buying wonderful companies at a fair price rather than a fair company at a wonderful price, defines an investor as “an individual whose investment provides two quantitative qualities — safety of principal and an adequate rate of return.” There are many intricacies within business ownership investments, but does everyone in the stock market consider these particulars when investing in business ownership? Of course not, because not everybody in the stock market is an investor. Individuals who desire to become investors must enter the arena with goals that have a long-term investment horizon. Warren Buffett, a global financial market guru and head of Berkshire-Hathaway, puts it best when he says: “It’s bad to go to bed at night thinking about the price of a stock. We think about the value of a company and the company results; the stock market is there to serve you, not instruct you.” Hence, an investor does not buy a price and will not be affected by the ups and downs of the market. A sound investor buys well-managed businesses, with strong earnings growth and significant barriers to entry that will provide long-term security. A ‘purchaser of price’ is a speculator; a ‘purchaser of solid businesses’ with sound fundamentals is an investor.

First, how can anyone say the statement in bold above? Isn’t this more of a pipe dream than reality? How many companies in the last 6 years have these traits, but still have the share price not go up?

Second, how does Buffett value currencies? If you are going to use fundamental analysis in your trading decisions (and Buffett does) it seems that stocks and currencies would require a much different analysis. There is no business to analyze when trading currencies. Trend followers of course ignore the fundamentals and trade the price action instead.

Gary Anderson of Equity PM goes after the skeptics of price-based trend following:

Skeptics hold that operations based only on observed price changes cannot succeed. Markets are moved by news, they argue, and since, by definition, news cannot be predicted (or it would not be news), price movement cannot be anticipated. It is a short step to conclude that price data are not linked and that price series follow a random walk. Skeptics fail to take into account that price activity is also news. As we have noted, traders respond to news of price change, just as they respond to other sorts of news. By their collective response traders forge causal links between past price data and current price movement. Price data are linked because traders link them.

The Currency Problem in Fundamental Analysis

The currency question cuts to the heart of the fundamental analysis framework. Buffett’s framework works for equities because a share of stock represents ownership of a business with cash flows, assets, competitive position, and management quality that can be analyzed and valued. The “investor vs. speculator” distinction has conceptual coherence in this context: the investor analyzes the business, the speculator analyzes the price.

Currency markets have no business to analyze. A dollar is not a claim on a company’s earnings. Its value relative to a euro or a yen reflects the aggregate of monetary policy decisions, inflation differentials, capital flows, geopolitical dynamics, and market sentiment. None of which can be reduced to the kind of discounted cash flow analysis that Buffett applies to equities. The fundamental analyst who wants to “buy solid businesses with sound fundamentals” in the currency market has no framework. There is no P/E ratio for the Japanese yen. There is no earnings growth rate for the Australian dollar.

Trend following applies the same rules to currencies as to equities, commodities, and bonds: read the price, follow the trend, size the position by volatility, exit when the exit rule fires. The absence of fundamental analysis is not a deficiency. It is the system’s key structural feature. The rules work because price trends exist in currency markets for the same behavioral reasons they exist in equity and commodity markets: participants respond to price news, and their collective responses create the momentum and persistence that systematic rules capture.

Anderson’s Answer to the Random Walk Objection

Anderson’s response to the random walk objection is the clearest available statement of why price data are not random. The objection says: markets respond to news, news is unpredictable, therefore price changes are unpredictable. The flaw in this argument is that price change itself is news. When crude oil rises 3% in a day, that price change is observed by thousands of participants who respond to it. Some buy because the trend is strengthening. Some sell because they interpret the move as overextended. Some who were waiting for a breakout level now receive the signal to enter. The collective response to the price change creates the next price change. The data are linked because the participants who observe and respond to price changes are the same participants who produce the next price changes.

This is not a subtle theoretical point. It is the operational description of how trend following works. The entry signal fires when price breaks above a defined lookback high. That signal fires because enough participants responding to the same price history create the momentum that produces the breakout. The breakout is partly self-fulfilling: the participants who see a 20-week high as a buy signal create buying pressure that extends the move. The trend follower is not predicting news. They are participating in the collective response to price news that creates the trends the system follows.

Frequently Asked Questions

What is the difference between an investor and a speculator according to Graham?

Graham defines an investor as one who obtains safety of principal and adequate return through analysis of business fundamentals. A speculator responds to price changes rather than to underlying business value. The distinction is meaningful in equity markets where businesses can be analyzed. It breaks down in currency, commodity, and futures markets where there is no underlying business to analyze and price is the only available input.

Why can’t fundamental analysis work in currency markets?

Because currencies are not claims on business cash flows. Their relative values reflect monetary policy, inflation differentials, capital flows, and sentiment, none of which can be reduced to the kind of fundamental analysis that Buffett applies to equities. There is no earnings growth rate, no P/E ratio, no balance sheet for a currency. The framework that works for equity investment has no application in currency markets, which is why systematic price-following approaches that ignore fundamentals work equally well in currency markets as in any other.

Why does Gary Anderson say price data are linked rather than random?

Because traders respond to price changes as news, and their collective responses create causal links between past and future price data. A price breakout is observed by participants who have buy signals at that level. Their buying creates additional price movement. The next group of participants observes the additional movement and responds. This chain of observation and response means price data are linked through participant behavior, not independent random events. The trend following entry signal is the systematic version of participating in this chain at its early stages.

Trend Following Systems
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