Understanding Trend Following for Investments
Executive Summary
- This article addresses the area of how to track trends in investing.
Introduction
It is easy to see when there are bubbles, but very difficult to figure out when that bubble will burst. This article covers how to track this.
On Trends
From Monday’s TrendCompass report: On 23 October, Yale economics professor, Robert Schiller gave a speech to a gathering of investors in Los Angeles. “I see bubbles everywhere…,” said the nobel laureate and author of “Irrational Exuberance.” Dr. Schiller famously predicted the bursting of the dotcom bubble in 2000 and the crash of the housing market in 2007, so investors rightly take his warnings very seriously.
The only problem here is that Dr. Schiller delivered his speech on 23 October of 2019, just over two years ago! That day, the S&P 500 closed almost exactly at 3,000. It has surged by more than 50% since then. Neither experts like Robert Schiller nor ordinary market participants can predict how long or how high asset prices might advance. – iSystems
*https://isystem-tf.com/2021/11/03/bubbles-bubbles-everywhere/
This is the exact problem. Both the housing and stock market as well as other bubbles have increased — in great part due to the Fed. If one had performed a value analysis and shorted any of these areas, one would have most likely lost money.
The Problem With Financial Forecasting
Strategies are often based upon what amounts to forecasting. One thinks that a company has good prospects and will be likely to go up in value. Or one thinks that an asset is in a bubble, and overpriced and then be likely to go down in value. This depends upon the idea that the item in question is forecastable. The effectiveness in financial forecasting is explained in the following quotation.
Forecasting commodity prices and economic indicators is demonstrably an exercise in futility. Our markets and economies are complex systems and as such, their future unfolding is impossible to predict with any degree of certainty. Concretely, let’s take a look at how the leading economic analysts did at predicting oil prices, GDP growth, unemployment and stock market indices.
Economists’ ability to predict commodity prices appears to be no better than their ability to predict economic growth, employment or stock markets. The oil market, the world’s largest and most closely studied commodity market, offers another example of the failure of forecasting. – iSystems
*https://thenakedhedgie.com/2016/10/20/economic-forecasting-is-exercise-in-futility/
The groupthink of forecasting is explained in the following quotation.
In January 2019, Reuters asked over one thousand energy market professionals to predict future oil prices. These experts thought that the barrel would average between $65 and $70 through 2023, close to where it was trading at the time. Just like the EIA 2003 example, this forecast reflects the groupthink that often prevails among well respected analysts.
Namely, forecasts affect their authors’ reputations. The farther they stray from the crowd, the greater the risk: if they get it wrong, and not just by a little bit, they could be subject to ridicule or worse. Thus, even if in 2003 some bold analyst correctly estimated that oil prices would more than double through 2005, their firm would be unlikely to publish such a forecast. From an institution’s point of view, it’s better to be wrong along with everyone else.
Trend Following is the exact opposite of financial forecast, which is explained in the following quotation.
Traders who employ a trend following strategy do not aim to forecast or predict specific price levels; they simply jump on the trend (when they perceived that a trend has established with their own particular reasons or rules) and ride it. These traders normally enter in the market after the trend “properly” establishes itself, betting that the trend will persist for a long time, and for this reason they forego the initial turning point profit. – Wikipedia
*https://en.wikipedia.org/wiki/Trend_following
The Fact of Trends
Tesla’s stock price appreciation would be difficult to justify on any rational valuation basis, but if your objective is generating investment returns then this point is in fact irrelevant. The undeniable reality is that Tesla – for whatever reason – had massively outperformed its peers in a trend that’s held for over a decade. It is important to understand that this is not an anomaly but only a recent, if spectacular example of the recurring theme: that markets move in trends. And once trends get going in earnest, they regularly eclipse our ideas about asset valuation, both on the up-side and on the downside. This happens regularly: it is not an exception that should surprise us.
Thus, Dimson, Marsh and Staunton included a massive chunk of stock market history across 18 global stock markets and gave us irrefutable evidence that trends really are the most potent driver of investment performance over the long term. This principle has held true through the two world wars, the 1930s depression, 1970s inflation, Korean War, Vietnam War, the collapse of the Communist Block, the rise of China, 911 terror attacks and the global war on terror. The century covered by this study has been one long roller-coaster for the global capital markets and through all of it, powerful trends prevailed as dominant drivers of investment performance. – iSystem
This is explained in the following quotation as well.
Shares of Tesla [TSLA] jumped by 12.7%, to $1,024.86 on Monday, which pushed the company’s market capitalization to $1.01 trillion. This might not seem a huge amount these days, when trillions are flying by left and right, but it’s still a huge amount. Tesla now has a price-earnings ratio of 332, in an industry where PE ratios of 10 to 30 are typical in good years.
But Tesla is special, CEO Elon Musk walks on water, and nothing and no one can touch them, especially not regulators, who get routinely brushed off.
And with this market cap of $1.01 trillion, Tesla was worth as much as the next 10 most valuable global automakers combined: Toyota, BYD (China), Volkswagen (VW, Porsche, Audi, Skoda, Seat, etc.), Daimler, GM, BMW, Ford, Stellantis (includes FCA), Honda, and SAIC Motors (China): – Wolfstreet
Is Value Investing a Fraud?
Now, it is true that for many people trend following is still a bit counterintuitive and difficult to accept as it involves buying assets only after their prices have already appreciated considerably and selling them well after their price has peaked. By contrast, value investing seems much more appealing since it involves shopping for investment bargains and buying assets at low prices.
Moreover, value investing has been championed by Benjamin Graham and Warren Buffett, two of the most successful investors ever. Well, here again we’ll fall back on one of our pillars of long-term success at investment speculation: TRUTH – and the truth is that both Graham and Buffett owe their success entirely to momentum investments rather than value picks.
Conclusion
This really just begins the topic. The next question once one concludes that one should invest based upon trends is what tools to use to identify these trends.