How Trend Trading Compromises the Market

There are three basic approaches to stock market “investing:” fundamentals analysis, charting theories and raw trend trading. Obviously, some market participants mix two or more of these approaches to some degree. By fundamentals analysis, I basically mean a Value Line or Graham & Dodd approach to buying and selling. The other two approaches depend on one or another type of trend analysis. Raw trend trading is simply jumping in and out of the market to go long on up trends and short on down trends, with little real consideration given to the fundamentals of the stocks selected. How is it so little attention needs be paid to stock selection, according to investment criteria, in order to successfully trade the market trends? That is the core question. Obviously, a disconnect has clearly arisen between company performance and stock market price performance. Why?

I argue that all forms of trend analysis and trading – anything but classic investment criteria buying and selling – compromise on the performance of the stock market as a market per se. What do I mean, you say? By compromising on the performance of the market as a market per se, I mean the following:

1. Market prices less accurately reflect true company performance;

2. Market prices move less independently of each other;

3. Herd behavior and band wagon effects become more dominant;

4. The market becomes more volatile and less stable;

5. The market is more amenable to manipulation by major players;

6. The market is more open to trading abuses;

7. The market disconnects from reality and has internal life of its own;

8. The market is more inclined to react to irrelevant information;

9. The market also overreacts to external information;

10. The market has a shorter term memory;

11. The market seeks new information to overreact to; and

12. The market is more disposed to bubble up and to crash;

In short, the market does a less good job by far of accurately reflecting companies’ current actual and expected performance and of distinguishing between companies in the market and having their stock prices move more independently of each other in the shorter term. These are major failings for a market.

None of this should come as a surprise. The more buying and selling in the stock market is based on factors other than underlying actual and expected company performance based on fundamentals, the less well market prices will reflect that performance and those fundamentals. The reverse is true as well. The more actual company performance becomes irrelevant to buy and selling stocks, the more the stock market takes on the characteristics (1) through (12) above and the less effective the market becomes as a market for the stock of those companies. These may not be popular notions, but that does not alter the truth of them.

The real difficulty is that, given these results from trend trading and given the market’s consequentially developed failings, it is still not unreasonable to engage in trend trading. More do it all the time, in one time frame and manner or another. That is because, for everyone, the market is about making money, not about the health of the market per se. But the situation does become a vicious circle and the problems (1) through (12) above are exacerbated the more trend trading occurs. The market is further compromised. Trading manipulations and abuses become more prevalent.

As a practical matter, I believe that little can be done about this problem, but it is very much worth noting and keeping an eye on because it does have a strong bearing on what you should be able to expect from your investments, especially in the shorter term, if you invest using classical investment criteria.

Disclosures: DXD, QID, SDS, SKF

Comments

[Ricard:]

Good article. I see a conflict between fundamental aspects of the investing business and efficient market theory.

As a Graham and Dodd follower, I would advocate throwing the latter out the window, and just sticking to the former. The markets WILL overshoot, WILL be at times totally and utterly irrational, and WILL fail and require intervention. Such is human nature.

Nov 04 10:47 AM

[logicalthought:]

Pricing distortions due to "trend trading" (or any other "technical methodology") create opportunities for fundamental investors with longer timeframes. At the end of the day, the value of a company is determined by its cash flow (or future estimates thereof), so if its stock price gets too far out of whack, some entity (a PE firm or a strategic investor) will come along and buy it.

Nov 04 10:48 AM

[Thad F:]

I am a trend trader using fundamentals and I have noticed that my time frame gets longer as the VIX stabilizes. I dont think there is a negative effect on the health of the market from us trendies as the only traders really exposed to short term losses are us. As for longer term pricing fundamentals still rule.
I choose to battle the HAL 9000 on the short term and consider it to my advantage that my volume is so small I can get in and out faster than them. My only gripe is getting bad order fills on thinly traded stocks so I avoid thinly traded stocks unless my time frame is longer.

Nov 04 11:21 AM

[Kimball Corson:]

Logical thought says
"Pricing distortions due to "trend trading" (or any other "technical methodology") create opportunities for fundamental investors with longer timeframes. At the end of the day, the value of a company is determined by its cash flow (or future estimates thereof), so if its stock price gets too far out of whack, some entity (a PE firm or a strategic investor) will come along and buy it."

Basically, although I am often a trend trader too, I think this is correct, as long as a fundamental investor will go both long and short and if that investor is truly in for the long term and not worried about being clobbered in the shorter or medium run. A very low internal rate of discount and considerable patience is necessary to succeed here and, unfortunately, financial confusion and turmoil of the type we have had, strong tends to raise internal rates of discount and generate more trend trading, making the problem worse. My argument is the market is sick, not that it is dead.

Nov 04 09:28 PM

[THofler:]

I call it momentum chasing. It's been around for as long as we've had market bubbles, including tulip mania. The only sensible thing we can do to curb its excesses is to be serious about capping trading margin and leverage in general. That includes the leverage of investment banks.

Nov 04 11:48 PM

[Kimball Corson:]

What do readers here think would happen in regard to trend trading if an exchange rule were adopted requiring say a two week or one month delay between order placement and order fulfilment. Would the market be healthier in the sense of having prices better reflect companies' performance or would the trend traders yell so loudly no one could hear themselves think.

Nov 05 05:29 PM

[untrusting ...:]

Kimball,
The better option would be to more heavily tax ultra ST trading transactions. For example, tax trades that occur in 1 week or less at $.03/share. Ultra ST trades contribute nothing to the main purpose of the markets, ie capital formation. Ultra ST trades are mainly a parasitic function that attempts to generate large profits for those can game the system the best.


On Nov 05 05:29 PM Kimball Corson wrote:

> What do readers here think would happen in regard to trend trading
> if an exchange rule were adopted requiring say a two week or one
> month delay between order placement and order fulfilment. Would the
> market be healthier in the sense of having prices better reflect
> companies' performance or would the trend traders yell so loudly
> no one could hear themselves think.

Nov 11 07:33 PM