The Trend Is Your Friend Until It Ends

Some financial equations do work. Good hedge fund + bad quarter = buying opportunity. As I expected, many hedge funds have performed well so far in 2009. It is no surprise that market dislocations, misvaluations and panic-selling hysteria created fantastic opportunities for skilled managers. Inevitably performance was bound to be strong when so many "experts" even recommended to avoid hedge funds! Redemptions by those that didn't understand true diversification have benefited investors who reduced risk by having lots of good hedge funds in their portfolios.

Even more impressive are the hedge fund managers that made money in both 2008 and 2009. Market timing is difficult but some have the talent. A good way to evaluate any investment strategy is its return on risk. Even with the recent stock and credit market rally, the return on risk of long only funds has been very low. Is the equity risk premium zero or negative? I don't know but unhedged stock market exposure is too unreliable for investors wishing to grow and preserve their capital. Invest in managers with the skills to make money when things go pear-shaped - when markets or economies go bad.



All trends end. Strange how those who argue trend-following hedge funds have no value continue to advocate long only equity because of an upward trend that can supposedly be extrapolated far into the future. Their insouciant belief in past being prologue is dangerous for investors. The volatility of recent years has shown pear-shaped times provide the best risk management stress test. As we saw with stock, credit and commodity markets recently, the more long-lasting the trend, the more violent the end. The trend is your friend until it ends.

The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fund groupies sell a rosy view of a future that we can all apparently look forward to...eventually. I hope they are right but consistent capital growth requires mitigating the downside. Few investors can afford to ignore drawdowns or volatility. Follow the trend? Into the abyss? Many equities drop to zero but none has ever gone to infinity. Portfolios need to be structured for amy possibility including a dystopian long term.

Some absolute return strategies went pear-shaped in 2008 like CB arbitrage and long biased equity. The returns have stormed back this year by those managers with the skills to achieve them. Meanwhile good managed futures CTAs and short biased funds continue to deliver essential negative correlation to their clients. Fiduciary duty requires portfolio construction for optimistic and pessimistic scenarios. Bear markets or bull markets are irrelevant in robust strategy allocation.

Since most phenomena are non-linear it stands to reason that linear equations are of limited use. The simplest pear-shaped formula is y^2=x^3-x^4 which only has solutions in the real world for inputs between 0 and 1. We can define the beginning of anything at zero and ending at one. Identifying and jumping onto a trend is relatively easy. Lots of people make money in bull markets. Knowing when to reverse into a short position is what separates the alpha players from the beta repackagers.

Unfortunately the crowd still uses normal assumptions which is fine until things cease to be normal. Pear-shaped situations require pear-shaped analysis. I'm not a quant but I've always preferred non-linear pear-shaped equations since they capture the initial quasi-linear uptrend and then model the volatile end game. We don't know the future but we do know that there are always securities to short sell and others to buy.

Many things exhibit pear-shaped characteristics. The universe is pear-shaped. Time is certainly pear-shaped. Just ask Professor Stephen Hawking. Atoms are too. If the largest and smallest physical systems are pear-shaped, it would seem possible that financial processes could also exhibit a similar form. Bonds and loans are great assets till the borrower defaults. Mortgage backed securities are fine unless real estate goes pear-shaped. Bull markets last longer and have low volatility while bear markets (pear markets?) are quicker but often eviscerate years of growth from the prior bull market.

Recently I reread some books on the economic shape of the world. One was The World is Flat by Thomas Friedman. While interesting, the premise is incomplete. The world is actually pear-shaped and only gives the illusion of flatness during easy times. Protectionism may be ending the globalization trend. While David Smick's book The World is Curved is more insightful, we need techniques to prepare for the different scenarios beyond the curve. Perhaps I should write a book called The World is Pear-Shaped.

Invention eliminates the obsolete. The life-cycle for businesses shortens all the time. Corporate and even country hegemony is not as long term as it used to be. Typewriters, slide rules and vinyl records all had rising sales for decades but have not had much "growth". Innovative strategies that seep into the public domain and crowded trades are prone to end with a meltdown. Bubbles take a long time to form but a short time to end. The best alpha generators are those managers equipped to navigate difficult markets. Successful trend following requires good entries and exits.

Comments

[Roger Knights:]

I like what this article says, so I've excerpted the best parts:

"All trends end. Strange how those who argue trend-following hedge funds have no value continue to advocate long only equity because of an upward trend that can supposedly be extrapolated far into the future. Their insouciant belief in past being prologue is dangerous for investors. The volatility of recent years has shown pear-shaped times provide the best risk management stress test. As we saw with stock, credit and commodity markets recently, the more long-lasting the trend, the more violent the end. The trend is your friend until it ends.

"The potential return from stocks fails to compensate for their notorious risk. Most economists and "passive" index fund groupies sell a rosy view of a future that we can all apparently look forward to...eventually. I hope they are right but consistent capital growth requires mitigating the downside. Few investors can afford to ignore drawdowns or volatility. Follow the trend? Into the abyss? Many equities drop to zero but none has ever gone to infinity. Portfolios need to be structured for amy possibility including a dystopian long term.
.................
"Fiduciary duty requires portfolio construction for optimistic and pessimistic scenarios. Bear markets or bull markets are irrelevant in robust strategy allocation.

"Since most phenomena are non-linear it stands to reason that linear equations are of limited use.
................
"Unfortunately the crowd still uses normal assumptions which is fine until things cease to be normal. Pear-shaped situations require pear-shaped analysis.
............
"If the largest and smallest physical systems are pear-shaped, it would seem possible that financial processes could also exhibit a similar form."

Oct 05 04:18 AM

[Moon Kil Woong:]

This is the all too typical upward skew. Even if you are favored to win most of the time, under these constraints your gain is offset by the less frequent downward moves. The recent market bull and bear tracks so well to this it's a bit hard for anyone not too see the relationship.

Veryan Allen, you should be an options trader. Once you understand skew and the value of locking short term gains and going delta neutral to avoid steep losses you have mastered what most "financial experts" cease to ever get through their thick skulls. There is no free lunch. Just hard work.

Oct 05 04:19 AM

[TradingHelp...:]

The trend wasn't my friend in early to mid 2008. It was lying to me.

Likewise the trend in Dec 09 to Feb 2009 was also a liar.

The trend might be your friend is you make friends quickly. If you give your trust slowly, you are likely to be burned in these markets.

Oct 05 05:02 AM

[TradingHelp...:]

Sorry typo. Should read Dec 08 to Feb 09.

Oct 05 05:02 AM

[chap08:]

Unfortunately not every hedge fund is a good hedge fund. Far from it. It is also hard to tell the bad from the good. Historical performance doesn't show you. Neither does professional experience. Many money managers invested with Bernie Madoff. He was not the only fraud waiting to be exposed and certainly not the only fund to go bust. Investing in these funds is a bit like buying a CDO. How much do you really know about how it generates returns? Closing your eyes and dreaming is not a good way to invest. Don't trust a AAA rating or a fee earning middle man. Particularly when you're paying 2 and 20 for the privilege.

Far better to do it yourself. There are some simple things that you can do which will give you the majority of the benefit. Pick your own style, but learning from, say, the Mebane Faber approach is not a bad starting point.

If you don't want to do it yourself then have faith in buy and hold. The world is only pear shaped in the very long term. In 50 years time US and global GDP will be higher than they are today. Stocks will have roughly risen in line. Wages and houses will have roughly risen in line. Just avoid the classic mistakes of buying high/selling low and paying high fees - particularly the 2 and 20 for hedge funds.

Oct 05 06:07 AM

[Michael Clark:]

The trend is ending. The pear-shape is returning.

seekingalpha.com/insta...

What looks like a pear from above looks like a cherry from below.

Oct 05 07:30 AM

[Michael Clark:]

Chap:

I think I agree with your final chapter. Although at some point the GDP growth of Ancient Rome transitioned to the GDP collapse of 1,000 years of Dark Ages....I don't think we are there yet, but we will be some day. That's a pear shape we can't forget.


On Oct 05 06:07 AM chap08 wrote:

> Unfortunately not every hedge fund is a good hedge fund. Far from
> it. It is also hard to tell the bad from the good. Historical performance
> doesn't show you. Neither does professional experience. Many money
> managers invested with Bernie Madoff. He was not the only fraud waiting
> to be exposed and certainly not the only fund to go bust. Investing
> in these funds is a bit like buying a CDO. How much do you really
> know about how it generates returns? Closing your eyes and dreaming
> is not a good way to invest. Don't trust a AAA rating or a fee earning
> middle man. Particularly when you're paying 2 and 20 for the privilege.
>
>
> Far better to do it yourself. There are some simple things that you
> can do which will give you the majority of the benefit. Pick your
> own style, but learning from, say, the Mebane Faber approach is not
> a bad starting point.
>
> If you don't want to do it yourself then have faith in buy and hold.
> The world is only pear shaped in the very long term. In 50 years
> time US and global GDP will be higher than they are today. Stocks
> will have roughly risen in line. Wages and houses will have roughly
> risen in line. Just avoid the classic mistakes of buying high/selling
> low and paying high fees - particularly the 2 and 20 for hedge funds.

Oct 05 07:46 AM

[YoYoMama:]

Wow. Cherries and pears. Sounds like fruit salad, only I don't know which are the fruits, the predictions or the predictors.

What has served many well in this environment is discarding the tired and untrue hypothesis of EMH, and buying or selling into the trends. Those who did so did not take massive losses on the plunge, and have benefitted from the rally.

Oct 05 08:57 AM

[Longinvestor:]

Nice article. Here is an article that confirms some of the hypothesis of the article:
"how the finance gurus get risk all wrong" by mandelbrot & taleb.
money.cnn.com/magazine...

Oct 05 09:18 AM

[chap08:]

Michael, it's an interesting one, but the evidence suggests that global GDP was much higher in the Dark Ages than before the fall of Rome. I don't know how reliable the estimates are but the ones I've seen certainly suggest this. Does your comment mean that you have other evidence? What's probably more reliable are population estimates. These show that population continued to grow as you would expect. This means that if GDP had not also grown significantly, then GDP per capita must have fallen dramatically. This is very unlikely in a global economy dominated by agriculture and basic needs. After all, they were only called the dark ages because Petrarch knew less about them, not because the lights went out.

The story was probably different for a tiny elite in Rome itself. But that's what you get for over spending on your military.

On Oct 05 07:46 AM Michael Clark wrote:

> Chap:
>
> I think I agree with your final chapter. Although at some point
> the GDP growth of Ancient Rome transitioned to the GDP collapse of
> 1,000 years of Dark Ages....I don't think we are there yet, but we
> will be some day. That's a pear shape we can't forget.

Oct 05 09:19 AM

[AndrewBaker:]

Trend following and momentum together can make you a lot of money, and lose you a lot too. But using an amalgam of charts, fundamentals and psychology (through noting what is being said and done and looking at indices that chart opinion), can give you an edge that makes for much more successful trading.

Buy and hold alone does not work, and day and short term trading, unless using leverage, is problematic due to costs: but trading a trend with momentum can last from a day to a long time and give good profits over any period. One important factor here is not to worry too much about the first and last few percent of the run: these are useful in signaling and confirming trend direction changes. Buy after the trend has established itself, and sell after the reversal has shown itself. The loss in so doing will be less than the loss caused by buying in and selling out too soon.

Oct 05 09:35 AM

[TA:]

Actually 2 good articles in one day although the moronic 'top 10' commentors on this site have ruined it with their plentiful facts and figures on why we should go down. Too bad none of them have a clue on how to make money.

Oct 05 11:58 AM

[buddhabill:]

2 quick thoughts:

First, my wife is pear-shaped...8 3/4 mos. pregnant! Her belly that has taken 9 months to grow will radically change some time in the next week or so. Pear-shaped world indeed.

Second: TA - you gotta lay a pearl of wisdom on us after a blast like that. Thanks in advance for your wisdom.


On Oct 05 11:58 AM TA wrote:

> Actually 2 good articles in one day although the moronic 'top 10'
> commentors on this site have ruined it with their plentiful facts
> and figures on why we should go down. Too bad none of them have a
> clue on how to make money.

Oct 05 06:01 PM

[Erick Tippett:]

You're absolutely right. One must understand "true diversification"
in order to have had any beneficial involvement with hedge funds
during this cycle. And of course one must have some medium
for knowing which hedge funds were going to be lucrative and
which ones were not and most people either lack the skill and or
or patience you apparently possess, if in fact you experienced the success you've claimed.

Erick Tippett
Chicago, Illinois

Oct 05 06:55 PM

[mbkelly75:]

Trends end - that is what trailing stop-losses are for. Every Bull Market is followed by a Bear Market which is followed by another Bull. The only sure thing about the markets is that they will eventually go up as well as down. Both are legimate trends and both can make you money. Even a sideways market can make you money if you do it right. The Balanced Portfolio Fund has shown for a long time now that a balanced portfolio has it's benefits in ANY market. You do not need them to make your own though - it is not that difficult. My own portfolio right now is 34% Bonds, 16% Gold and Silver, and 50% Dividend-Paying Stocks with a record of +5 years of RAISING dividends. I have done well for years with this same basic portfolio - the only real changes being that the PMs can move from 6%-16% and the 50% stocks can be 60% to make up the difference.

Oct 05 07:19 PM

[RiskAverseA...:]

National hegemony is not as long term as it used to be? Is this to say the nearer trend will sooner bring a rising demonstration of hegemony among various sovereign nations?

Oct 05 09:18 PM

[rennert:]

The trend is inflation and less money in consumers wallet. Just came back from K-Mart the prices are looking very inflationary just like my grocery store isles. Good Will Stores will be the new Walmart and K-Mart.

Oct 05 10:41 PM

[jmann83:]

Like warren buffett says ''when the tide goes out you can see who was swimming naked'' the expansion and contraction of credit has been the cause of booms & busts since the dawn of time, no different this time, its a Darwinian flush. Thank god I was market neutral throughout the whole episode, the volatility actually produced great gains to those who could recognize the opportunities.

Oct 06 03:37 AM