Good Picks Can Be Clobbered by Trading Trends

We speak of strategies like perhaps this is a good time to be invested in emerging markets, Latin America or perhaps China or maybe even the BRICs, typically by means of spdrs, ADRs, mutual funds, ETFs or the like. Often these strategies are considered defensive plays where there is a lack of confidence in U.S. companies, the economy or the stock market, but good confidence in what is developing elsewhere. The problem is too often this approach does not work, at least in the short term. Why? Because the market on a downward tear, for example, takes just about everything with it, except maybe gold and a few similar picks. A downward tear seems more likely these days, if Friday, October 30th, is any indication, when the DOW dropped by almost 250 points and the NASDAQ, by over 52.

Although Brazil may be on a terrific upswing, BRF and EWZ will sink or drop along with everything else. That China is trending up doesn´t matter; your Chinese GXC and FXI will tank along with the rest of the market. Ditto for emerging market funds such as ESR and EWX. Your BRIC fund BIK will sink like one. The market takes the good, the improving and everything else all down together when it is dropping quickly. Why? I think simply because they are there and in the same market. A collective herd mentality indiscriminately takes hold. Buyers and sellers react emotionally and do not discriminate.The good sink with the bad and the over-priced. The drop is not about individual funds or stocks; it is about what the market itself is doing and participants getting out of it.That things might well sort themselves out much further down the road is little consolation for the adversities and losses in the here and now.

Several years ago, before the Great Recession, but after problems in the world economy began to emerge, The Economist Magazine attracted much attention by arguing that the emerging markets were no longer closely coupled or tied to American and European markets. The emerging markets had "decoupled" and now had independence and freedom of movement, we were told. I was skeptical, as were others at the time. The financial collapse of the Great Recession made it quite clear how wrong the Economist Magazine was, at least in regard to financial markets. Indeed, world financial markets are closely tied together.

It was an example of what economists jokingly refer to as Walras’ third law: ‘everything is related to everything else.’ America sneezes and Ecuador catches a cold. So perhaps the good sinking with the bad or over-priced is not just a stock market phenomenon, but a larger real or financial one as well, at least to an extent. But again, in a market on a downward tear, is this the market’s prescience, or simply a friction or vacuum effect of being along side? I suspect the latter. It is kind of like being financially rear-ended.

This phenomenon has several untoward consequences, generally. First, it makes it harder to determine what a good stock, mutual fund or ETF pick is, at least short term, by looking at price performance. This is because performance gets separated from the company’s or fund’s fundamentals in a strongly trending market. Secondly, it is hard on the truly good picks. Instead of basking in their earned glory with rising prices, they sink with the market trend and the bad and over-priced apples. Thirdly, depending on your internal rate of discount, even if your careful picks will do better in the longer run and stand out then, the beating you can take in the short run by having them move with a downward trend can be prohibitive. These facts, in turn, themselves have significant consequences for the market.

What we observe is why many players in the market are much more concerned about going long with the trend if it rises and short with the trend if it drops, rather than in picking good solid stocks, funds and ETFs. Playing the trend and believing the trend is your friend are nothing new. You can aggressively go after trying to pick the turning points or like old J.P. Morgan (JPM), you can sit back and take your bite out of the middle. There are many kinds of trend players and many time frames within which to play trends. The argument is you don’t care how good your picks might really be on a Value Line or Graham & Dodd basis, because if you fight the market, using those selection criteria, you can get clobbered. If you go with the trend, even riding picks that are known dogs, you can make money. Quirky, but true. In this case, a changing tide lifts or lowers all boats, even those about to sink.

The problem is that the net result of these developments, if too many market participants become trend players instead of investors, is the market begins to look more like a casino and it more readily disconnects from the real economy and the companies whose stocks are involved. It becomes less and less like a forum for good secondary investment, according to time honored investment principles. Herd behavior, band wagon effects, manipulation and the like are able to generate increasing instability in such stock markets. Such increased volatility is viewed opportunistically by traders playing the trends, even if they are only daily ones. At the same time, stock markets become more amenable to bubbles and their consequences. The market incentives to participants have become non-optimal.

These are not developments we should like to see. They reflect on the health of the market as a market per se. They leave us few safe havens in the event of a down pour. They can waste or compromise a lot of good work on careful stock or fund selection and they can send mixed signals to IPO and secondary offering markets. These matters go far to keep money market funds in business and brokerage cash accounts active and busy. But what are reasonable market participants to do?

Disclosure: no relevant positions

Comments

[Angel Martin:]

Another really good article.

It suggest to me that real diversification is allocation to different asset classes (corporates, sovereigns, high yields, precious metals, commodities, real estate), rather than the same asset class (eg stocks) across different countries.

Nov 01 11:32 AM

[Ricard:]

There is a defense for this.

Read Ben Graham and his analogies with 'Mr. Market'. Pick a price, and begin accumulating once the stock drops below that price.

I did that with ACH, at 20. I'm sitting on nearly 200% gains, half realized and half unrealized.

Nov 01 12:32 PM

[Jeez:]

Good points, but presented in a repetitive and incoherent manner. However, this is a serious matter for all who seriously want to be investors and hope to think that market is "fair" and not unreasonably expect a decent return for good research and willingness to take reasonable risk.
After watching the market action, I strongly believe that there are too many trigger happy traders and too many algorithmic (computer based) trades taking place.

Nov 01 08:52 PM

[CoVo:]

I've been trading for about 15 years. My results have been getting better with time. Now I just find the best companies I can, usually using price/cash flow as my main guide.
Then I buy if its above its 60 day moving average and sell if it falls below the 60 day moving average line.
The main advantage is that this saves me a lot of time.

Nov 02 10:47 AM

[sacking:]

Yes, throwing out the baby with the bathwater happens. I've been in EWZ, ILF and BRF for awhile now. They go up faster than the overall market, and unfortunately, fall faster than the overall market. I agree that long-term, these are great buys, but short-term, I get a stomach ache watching the market go up and down by hundreds of points each day.

Nov 02 11:33 AM

[Mad Hedge F...:]

sdg If someone mentions the word “decoupling” to you, turn around and walk away, delete their number from your Blackberries and I-Phones, delink from their Facebook page, and block their Tweets and e-mails. Knowing this individual will be seriously injurious to your wealth. When the stock market rolls over, don’t expect to be able to hide anywhere, except in cash. The way all assets classes simultaneously piled into the “down” elevator at exactly the same time last week is proof of how highly correlated markets are these days. The causes are mega hedge funds with newly tightened risk controls and itchy trigger fingers, vast quantities of stock electro shocked by computer algorithms, and too recent memories of the bloodletting earlier this year. I have always viewed diversification as a great way to lose more money in varied places with more exotic sounding names. Remember the old saw that when America sneezes, the rest of the world catches cold? Now when the US says “katchoo”, the everyone else catches the H1N1 virus, AIDS, and the bubonic plague. The US has become on the canary in the coal mine that warns of deadlier global contagions. There is really only one trade these days. Is the world getting better, or not? Only the volatility will vary across instruments and countries. As much as I love China (FXI) and commodities for the long haul, when the US markets drop, I expect them to plummet twice as fast.

Nov 02 02:15 PM

[Kimball Corson:]

Excellent expansive comments, Mad Hedge Fund Trader.

Sacking understands the core problem well and at a viseral level.

CoVo works a system and apparently doesn't worry much about the short run. Ricard seems to be somewhat in the same camp.

Angle Martin recognizes that with trend trading diversification does not afford the protection many think.

Me, I worry about major corrections. It can take along time for a portfolio to recover from a crash, even if you escape before the very bottom.

Interestingly, no one, except perhaps Jeez, addresses how trend trading and program trading based on trends damages the market, from an investment point of view. Among other things, it facilities asset bubbles that sound investment buying and selling would not permit. The problem though is trend trading is not unreasonable, especially if others do it and good results can be obtained. If trend trading could be somehow outlawed (what a mess trying would be), I think we would see an entirely different kind of market and a much healthier and more stable one, where sound investment criteria became the norm and there was much less volitility and a closer connection between price and company performance. The market would better track companies' performance and investment criteria would prevent bubbles or at least make them much more difficult to develop.

Nov 02 04:27 PM

[surfgeezer:]

Great article. My personal experience is in real estate, but the parallels are uncanny. As an investor I use multiples of rent to determine value and cash flow. I quit looking for new real estate deals in 2002 as the multiples became IMHO untenable. For me the "flippers" ruined the market, although many made money buying then and selling before 2008. If you are very good at "timing" you can make money in any market. I do not pretend to have the kind of information or acumen. I do know my earlier purchases still generate positive cash flow.
There are several important rules that work in both markets. 1-location- people want to live there and it will retain relative value and cash flow, for equities it is slightly harder but quality companies without too much debt, low p/e and high dividends, and now in countries that are likely to grow/currency appreciate faster than U.S. are where I put the percentage of my overall portfolio devoted to stocks and bonds.
Like my real estate they could drop considerably in a mark to market evaluation, but like my real estate I am not selling. I want cash flow and that is still there. If you look at the cash flow on the original investment people would have a lot less angst.
Mark to market is for flippers-I don't care.
Cash flow is for investors.

Nov 02 05:29 PM

[Ricard:]

Not sure if you caught my point.

Trend is something that can be ignored in investing, especially if you do not use leverage or margin.

In my ACH example, I was looking at one point a 65% unrealized loss when I initially bought at 20. However, instead of following trend, I continued to DCA down until I lowered my average buy price to 10. The stock is now around 28.

What made such an investment possible was a total disregard for trend investing, and using a more fundamental analysis.

On Nov 02 04:27 PM Kimball Corson wrote:

Nov 04 01:14 AM

[rkTrading:]

Great read (especially the comments). Just a short note that options on emerging markets ETFs are one of the most active (EEM, FXI, EWZ, etc... ). This contributes to short term volatility in the underlying.

Nov 16 11:32 PM