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The Speculator
Why the trend is not your friend
Many technical traders
stake their futures on following the crowd. But every trend can turn
on you, because what goes up usually comes back down -- and vice
versa.
By Victor
Niederhoffer and Laurel Kenner
The stock market has been a trend-follower’s dream
for the last few weeks. On March 22, a close below 1,150 in the
S&P 500 futures set all the bearish indicators in motion.
Confirmations of a downward trend through regression lines, moving
averages, pivots, Bollinger bands, you name it, were triggered. Over
the next 24 trading days, the market closed 10 times at 20-day lows.
Rule
No. 1, carved in stone for all technical analysts, is that the trend
is your friend. If ever there were a time that we could, along with
the Cabot Market Letter, report the beauty of using a simple
trend-following indicator that makes it “virtually impossible to
miss a major market move,” this would surely be that time. No wonder
that 830 aspiring chart-readers, the most ever, registered for the
Market Technicians Association’s annual competency exams on April 26
in Jupiter Beach, Fla.
Granted that some users of trend
following have achieved success. Doubtless their intelligence and
insights are quite superior to our own. But it’s at times like this,
when everything seems to be coming up roses for the trend followers’
theories and reputations, that it’s worthwhile to step back and
consider some fundamental questions:
- Is their central rule, “The trend is your friend,” valid?
- Might their reported results, good or bad, be best explained
as due to chance?
But first, a warning: We do not
believe in trend-following. We are not members of the Market
Technicians Association, or the International Federation of
Technical Analysts or the TurtleTrader Trend Followers Hall of Fame.
In fact, we are on the enemies list of such
organizations.
These posts on the TurtleTrader site, which
describes itself as the world’s No. 1 source for trend-following,
referring to an April 2001 interview with Vic in “Technical Analysis
of Stocks and Commodities” are typical:
“Niederhoffer says
that trend following doesn’t work, and is doomed to failure. Here’s
a guy who blew up his own trading account in a spectacular fashion,
and he’s knocking systematic trend following
“Niederhoffer,
like so many, ignores the bottom line success of trend following. To
accept any of what Niederhoffer says is to ignore the existence of
Bill Dunn, Jerry Parker, Richard Dennis, John W. Henry and all of
the many Turtles.”
But trends
always turn
Let’s turn to actual results on
trend-following, using annual data provided by the authors of
"Triumph of the Optimists: 101 Years of Global Investment Return",
which we consider the best investment book ever written (See our April 11
column.). As we reported last week, trends in annual returns
have been absent over the last 102 years. For consecutive years, the
correlation is -0.02. The correlation between the return in one year
and the return two years later is -0.25. In recent years, the
correlations have been even more negative; three consecutive
negative annual returns were last seen 70 years ago.
As
authors Elroy Dimson, Paul Marsh and Mike Staunton point out in
"Triumph," there have been only six occasions in the last 102 years
when the market declined for two years in a row. That’s not enough
for reliable statistical conclusions. But the average return in the
following year is 16% -- the highest possible third-year average of
all possible directional combinations for a two-year period, tying
with the down-up combination.
| Up/down combinations |
| Year 1 |
Year 2 |
Year 3 gain |
| + |
+ |
9% |
| - |
+ |
16% |
| + |
- |
13% |
| - |
- |
16% | |
Perhaps
short-term trends in the averages support the trend-following view?
No, not there, either. Correlations between consecutive
non-overlapping periods of various duration in the most widely
traded stock futures are negative, showing what is called mean
reversion. In other words, big declines in the averages tend to be
followed by big rises and big rises tend to be followed by big
declines. (Medium moves tend to be followed by medium moves.) A good
ballpark estimate for those correlations, for the statistically
minded, is -0.15.
The situation for individual stocks also
favors the anti-trend school. Jonathan Lewellen, an instructor at
MIT, wrote a series of papers showing that for the 66-year period
from 1932 to 1998, the average stock went back some 41% toward the
mean over the next six quarters vis-à-vis its performance in a
single year. From 1968 through 2000, Lewellen found the correlation
was -24% -- somewhat less, but still significant.
In other
words, if the return on a stock is 50 percentage points below the
mean in one year, the best prediction you can make for the next six
quarters is that it will go up some 24% x 50%, i.e., roughly 12%
above the mean.
After going through millions and millions of
careful calculations, and correcting for all the usual biases in
studies of this nature, Lewellen concludes: “The evidence for mean
reversion is strong.”
How is trend-following doing right now
compared with mean-reversion investing?
After all, academic
findings too often come down the pike at exactly the wrong time for
investors. In a classic example, a groundbreaking 1981 study showing
that small stocks consistently outperformed large ones was followed
by 18 years of small-cap underperformance. The bad stretch began in
1983, after a honeymoon period that gave the numerous new small-cap
investment vehicles inspired by the study enough time to attract a
lot of money. Dimson, Marsh and Staunton called attention to this
reversal of fortune in a 1999 article titled “Murphy’s Law and
Market Anomalies.” Ironically, the year the article was published,
small caps went on to record one of their best years ever; and in
2000 and 2001, they outperformed the S&P 500.
Normally,
after showing that all the evidence is against a theory, we would be
content to end with a snappy conclusion to the effect of “the trend
is not your friend.” Yet no fixed rule can be expected to last
forever. Too many smart people are around to anticipate and
dissipate the effect. Thus, the cycles are always changing, as
racetrack expert Robert Bacon first documented in his classic,
“Secrets of Professional Turf Betting.”
Will declines now follow declines?
Given
that the evidence over the last 60 or 70 years is antithetical to
the trend-followers on individual stocks -- and that recent evidence
on trends in the averages is equally unfavorable -- is there any
evidence that things are about to change?
After all, S&P
500 futures had three consecutive monthly declines in June, July and
August 2001, resulting in a drastic 10% decline. Then, from the end
of August to Sept. 21 -- well, the tale is too sad to tell. But the
market panorama is rich enough to find anecdotes that seem to
support any kind of market relation.
To find out whether the
cycle might be changing once again, who ya' gonna call? The
Speculators.
We took the 20 best and worst performers in the
S&P 500 during the year 2000. (The current S&P 500 contains
a few companies that were not around at the beginning of 2000, so it
was necessary to eliminate all such new additions from our
tally.)
Looking at the performance of these stocks over the
subsequent 16 months, through April 29, 2002, we found that the 20
best stocks of 2000 returned an average of -11%.
Calpine (CPN,
news,
msgs),
down 76%, PerkinElmer (PKI,
news,
msgs),
down 76%, and Allergan (AGN,
news,
msgs),
down 32%, were among the bests that stumbled. (The situation would
have been even worse if such stocks as Enron, a stalwart member and
top performer of the S&P in 2000, had been included. Enron was
delisted in November 2001, so we had to drop its bad results, which
would have taken an additional 5 percentage points from the 20
best.)
The 20 worst stocks of 2000 were unchanged in the next
16 months, on average. That list included stocks such as American
Greetings (AM,
news,
msgs),
up 91% from Dec. 29, 2000, through April 29, 2002;
Apple (AAPL,
news,
msgs),
up 55%; Cendant (CD,
news,
msgs),
up 91%; Circuit City (CC,
news,
msgs),
up 86%; and Dell (DELL,
news,
msgs),
up 48%.
The S&P 500 Index itself declined 19% in the
16-month period. In sum:
| Rankings and returns |
| S&P 500 stocks 2000 rank |
% return next 16 Mos. |
| 20 best |
-11 |
| 20 worst |
-0 |
| S&P 500 index |
-19 | |
Of
course, buying the worst is by no means the road to guaranteed
riches. Yahoo! (YHOO,
news,
msgs),
down 86% and the second-worst performer of all in 2000, went on to
lose 53% more in the subsequent 16 months.
Novell (NOVL,
news,
msgs),
Lucent Technologies (LU,
news,
msgs),
Gateway (GTW,
news,
msgs)
and WorldCom (WCOM,
news,
msgs)
saw similar continuity of losses.
Putting one consideration
with another, however, there is no recent evidence of a regime
shift. The weight of academic findings and practical results
indicates that the tendency to mean reversion is intact. We conclude
that evidence for all periods, all individual stocks, all averages
and all new indexes that we might reasonably think of is against the
trend-followers.
Our market shrink, Dr. Brett Steenbarger,
whose work is often featured on MSN Money, frames the issue this
way: Technical analysis is like an X-ray; it generates pictures of
market conditions. Accurate diagnosis, however, must determine
exactly how far conditions deviate from the norm and perform tests
that cannot be conducted by radiology. "For a trader to limit
himself to technical analysis is like a physician limiting diagnosis
and treatment to X-ray findings," he concludes. “A picture may be
worth a thousand words, but a positive finding on a blood test will
never show up on the picture.”
Final
note
The beginning of a month is always a good time for a
trend to change, and that’s when we like to buy individual stocks.
In view of the recent negative trends, this seems like a
particularly salutary time to participate in the 1.5 million
percent-a-century juggernaut. We are very bullish for this year and
the next, and we have been purchasing shares of companies that
announce buybacks and biotech stocks with a preponderance of recent
insider buying. Our buys in both groups are based on statistical
studies that we have reported on in detail here over the past few
months.
Since our list of buybacks was published on April
18, three others -- Charter One Financial (CF,
news,
msgs),
IBM (IBM,
news,
msgs)
and Kimberly-Clark (KMB,
news,
msgs)
have announced buybacks, and we will be buying them accordingly.
Of the 20 worst performers in the S&P in the last 12
months, we note that eight of them have recent insider buying:
| Companies with insider
buying |
| Company |
Ticker |
% decline 4/30/01-4/30/02 |
| Qwest |
Q |
-88 |
| WorldCom |
WCOM |
-87 |
| Vitesse |
VTSS |
-83 |
| EMC |
EMC |
-77 |
| Dynegy |
DYN |
-76 |
| Solectron |
SLR |
-72 |
| Gateway |
GTW |
-70 |
| Mirant |
MIR |
-70 | |
We
like them as a group, and we accordingly will be buying them. Four
-- Mirant, Solectron, EMC and Dynegy -- not only have insider buying
but have announced buybacks. Thus, according to our statistical
studies they are buys on three separate systems: buybacks, reversion
to mean and insider purchases. We’ll be buying double quantities of
these, with the exception of Dynegy, as it rose 30% on
Tuesday.
As we write on Wednesday, the Dow has rocketed above
the magical 10,000 once again and the seesaw has tilted in our view
to the short-term neutral. Thus, we will wait to accumulate all the
good issues mentioned on weakness rather than buying into this
recent strength.
We will be pleased to send you our workout
of the 20 companies in the S&P 500 that were the worst in 2000,
adjusted for survivorship bias. Please be free with your critiques
and encomia, especially the latter, as we anticipate a deluge of
vitriol from the trend-followers on this one. Write to gbuch@bloomberg.net.
At
the time of publication, Victor Niederhoffer and Laurel Kenner owned
or controlled shares in the following equities mentioned in this
column: IBM.
|
