Some words on trend following vs. alternative strategies, from a former Enron employee:
Greetings, I have examined and re-examined your website for over a year now, reading, studying and enjoying the straight-forward, no nonsense, a fact is a fact message that your site conveys; i.e. price alone is the sole determinant for initiating a trading decision. I wish I had learned of your site years ago. I would probably be a wealthier person. Being a former Enron employee, I totally agree with your statements regarding Enron’s stock price since early 2001. My fellow (former) colleagues have no one to blame other than themselves for allowing such disastrous losses to occur in their retirement accounts. An abdication of personal responsibility should not be rewarded. It is a sad consequence but it is reality. And now with all the hysterics over Worldcom, it proves, in my opinion, a couple of absolute truths regarding trading:
- Corporate stock prices respect neither opinion nor fundamentals.
- As long as people get sucked in by analysts’ rhetoric they will be forever playing a negative-sum game.
- The typical investor wants to be shielded from his bad decision-making (or lack thereof).
- Prediction is for…losers.
A trend follower probably saw the short signals at the beginning of 2002 for Worldcom, well before accounting irregularities surfaced. It is for these realizations that I wish to thank TurtleTrader. Your site is a breath of fresh air. You have convinced me that the mechanical, non-emotional, disciplined and systematic approach is the only way to trade. I refuse to be a lamb to the slaughter and will not trade until I learn this approach. I wish your site continued success.
What the Enron and Worldcom Collapses Proved
The writer’s four points are the practitioner’s version of what behavioral finance research documents academically. Corporate stock prices respect neither opinion nor fundamentals is the empirical finding from the Enron collapse: the fundamental case for Enron was positive right up until it was not, and the price had been telling a different story for months before the accounting irregularities surfaced publicly. The price was the leading indicator. The fundamentals were the lagging explanation.
The Worldcom short signal observation is the specific application. A systematic trend follower who enters short positions when price breaks below defined lookback lows would have been short Worldcom in early 2002, well before the $11 billion accounting fraud was disclosed in June 2002. They would not have been short because they analyzed Worldcom’s accounting. They would have been short because price was making lower lows according to their entry criteria. The accounting fraud was the explanation for the price behavior, discovered after the fact. The price behavior was the signal, generated before the explanation was available.
This is the structural advantage that price-reactive systematic trading has over fundamental analysis in situations of fraud, misrepresentation, or any other information gap between what management knows and what the public knows. The insiders who know the actual financial condition of the company trade on that knowledge, and their trading moves the price before the information is public. The systematic trend follower who follows that price movement captures the returns without needing to know the reason. The fundamental analyst who reads the reported financials is working with information that has already been filtered through management’s presentation choices.
The “negative-sum game” observation in point two is precise and important. The standard description of markets is zero-sum: winners gain what losers lose. But when broker commissions and management fees are factored in, the aggregate return to market participants is negative. Investors who follow analysts’ buy recommendations, who pay management fees to mutual funds that underperform their benchmarks, and who incur transaction costs churning in and out of positions are not playing a zero-sum game. They are funding the intermediary layer while competing for whatever is left.
The “refuse to be a lamb to the slaughter” formulation is the personal statement of the zero-sum insight. The lamb does not understand that it is being led to slaughter. The investor who follows analysts’ recommendations, holds diversified mutual funds, and trusts that the financial industry’s interests are aligned with their own is the lamb. The trend follower who understands that their counterparties include professionals with information advantages and that their only defense is a systematic price-based approach is not a lamb.
Frequently Asked Questions
How would trend following have protected Enron employees’ retirement accounts?
A systematic trend following approach that applied price-based exit rules to Enron stock would have generated sell signals when Enron’s price broke below defined support levels, months before the collapse became public knowledge. The exit would not have required knowledge of the accounting fraud. It would have required only that price fell below the defined exit level, which it did progressively through 2001. The employees who held concentrated Enron positions until near-zero had no exit mechanism. A systematic approach has one.
Why do corporate stock prices not respect fundamentals?
Because the fundamentals that analysts analyze are reported figures that reflect management’s presentation choices. When management’s reported fundamentals diverge from the company’s actual condition, as in accounting fraud, the reported fundamentals are not the actual fundamentals. The price, which reflects trading by participants with access to different information including insiders, often reflects the actual condition before the reported fundamentals acknowledge it. Price respects reality. Reported fundamentals respect what management chooses to disclose.
What does “prediction is for losers” mean in trading?
It means that approaches built on predicting future price movements, whether through fundamental analysis, Elliott Wave, analyst recommendations, or any other forecasting method, are systematically outperformed over time by approaches that react to what price is actually doing. Prediction requires knowing the future, which no participant does. Reaction requires only the current price and a defined rule for responding to it. The reactive approach does not lose the analysis battle to the fundamental analyst. It sidesteps the battle entirely by not playing it.
Trend Following Systems
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