No to Fundamentals

Larry Hite (appears in Broke) gave a speech a few years back. In his speech, a defense of trend following, he relayed a comical conversation about the never ending need of some to know the fundamentals:

Many years ago, I jumped up at three in the morning one night and started scribbling and calculating and said, “Holy shit, it’s not the number of the eggs, but the size of the chickens.” My girlfriend at the time looked at me and said, “You wake me up at 3AM to tell me size matters?” “You’ve got to understand,” I explained, “you can’t get large eggs from small chickens.” “What are you talking about?” I said, “Well I have been thinking about eggs.” She said, “Eggs? It’s three in the morning, what do you mean you•ve been thinking about eggs?” She said, “I thought you were a music guy or a drug dealer, why are you thinking about eggs?” I said, “Well here’s the thing about these eggs. There are going to be a lot of chickens next year. But if you regress the age of the flock there’s going to be a lot of small chickens and medium chickens but there are not going to be a bunch of old, large chickens. And without large chickens you can’t have large eggs. And without large eggs you can’t make the deliverable on the Chicago Merc which calls for large, white eggs. So there will be a shortage of deliverables in Chicago.” She said, “You know, I could have told my friends a lot of stuff about you. I could have even had lied to my parents. But I really can’t sleep with a guy who counts chickens.” That was what commodity trading was all about. It was about the fundamentals of a commodity.

Pick the market. Stock, commodity, future, whatever. If you find yourself trying to actually know all of the fundamental data for some market, doesn’t Hite’s story hit you in the gut? Bottom line, knowing the fundamentals doesn’t translate into making good buy/sell decisions and or making good money management decisions (“how much to buy or sell?”).

13 thoughts on “No to Fundamentals

  1. I agree mostly. But only mostly. I wouldn’t dismiss fundamentals completely.

    I now use fundamentals in my trading as a filter. Especially in stock trading you have literally thousands of possible signals. You cannot buy all of them, so you must filter.

    Here I use fundamental data mostly to decide what I *don’t* buy. I look for “red flags”, and when I see one, the stock gets uninteresting, because the risk/reward then is outside of my trading system requirements. Doing so, I don’t need all fundamental data, this would be indeed impossible.

    Just one example (german stock market): This May, the german corporation Arcandor gave a nice turtle long signal. But everybody who followed even only the public press knew that Arcandor was on the verge of bankruptcy. A simple look into the income statement was a hair-raising horror. Of course, one could have traded this stock and speculate on a turn-around. But the risk-reward here was horribly bad. The probability of complete loss was overwhelming. Sorry, not my taste.

    Btw: The inevitable happened. In June, just one month later, Arcandor had to file for bankrupty. The stock is now trading in penny space. There was even no chance to short this stock using a trend following system; upon bankruptcy, the stock fell more or less immediately into the abyss and stayed there.

    So why bother with this nerve-racking trash when there are a hundreds of stocks with nice uptrends *and* nice fundamentals?

  2. Size of the chicken counts because you can’t have any more bigger eggs from an aging company/trend. Look at current growth of Twitter & Facebook and the decline of former king MySpace, The story about size of the chicken & eggs is a good parable, you just have to look the story from the different angle.

  3. Steffen, I think the point being made here was actually about everything except what to buy.

    As an analogy, if you are playing poker and get dealt a pair of aces you know this is the best possible place to start.

    However if you were asked not just to risk what you had at the table, but everything you owned on that hand, would you take it knowing you have about a 1 in 5 chance of losing absolutely everything?

    The point is that knowing you are in a good position is one thing, but knowing when to get out, how much to risk etc is just as important.

  4. Thanks for the good laugh Michael. I guess that’s what happens when we get lost in mental abstractions.

    Experiencing is a different thing from explaining, totally different. All fundamental explanations are a trick to escape from experiencing. It is not only different, it’s self deception.

  5. Michael,

    I do think I got the point, but please feel free to correct me if I’m wrong:

    My interpretation of this little story: When you study fundamentals, you easily fall into the “more information!!! I need more information!” trap. But in financial trading, there is always information which supports prices going up, as much as information which says the opposite. Trend trading now says “forget all these fundamentals, price action is the *only* thing that matters”.

    Here I slightly disagree. Of course, when prices are going up, I want to have a long position, thats most basic. But trading is – in my humble opinion – about an edge in the markets. Can I get an edge just by looking at the chart? Thats the question. Everybody sees the chart. Where is my advantage?

    I found my advantage in including just a little bit more information than the pure chart. I don’t try to gather ‘every possible information’, I just check any trading position beforehand whether it might be garbage (I trade mainly stocks). By doing so, I avoided a LOT of losing trades so far.

    Thats my point; but as I said: Please feel free to correct me, of course, I might be completely wrong.

  6. Steffen,
    Having an edge isn’t just looking at a chart. Yes, everybody may see the chart, but is everybody interpreting it the same.

    Having an edge is in your exits, knowing that everybody who is looking at the chart doesn’t have the same exit you do. It is also in your risk management. Anyone can look at a chart, but have they backtested their entries, exits, and risk over time?

    Believe me, one can be successful trading equities with price alone. I did quite well in 2008, and am continuing that this year. Will I end the year with tremendous gains? I have no idea.

    As far as having a fundamental filter on your system, did anyone think Goldman Sachs would be close to double its price since March based on fundamentals, probably not. But it is.

    Take a look at Eric Crittenden’s research on “Does Trendfollowing work on Stocks”. Blackstar bought at all time highs regardless of the “funnymentals” (stolen from Ed Seykota).

  7. If you are working to uncover something that you believe is not already reflected in the price then you are predicting not following.

  8. In virtually all “economic” decisions, supply/demand and price rule, generally according to an individual’s “budget” for the item. For example, you notice a sale on socks (substitute any usable item) and you need several pair. You may buy more than you normally would at one time, due to the reduced price, but you do limit your purchase according to your need or normal usage. The “sock” market is sending a message that supply is greater than demand and they need to be brought into balance.

    With the “stock” or financial markets, there is generally no limitation on supply. Traders may think they know that they they have all the information available to support their purchase or sale decision. But, when stocks are in an uptrend (or downtrend) and demand is rising (or falling) on volume, they see what the crowd is doing. They assume that the crowd must have some information that they don’t. Most traders follow the crowd and their endogenous feelings. What else could explain sudden market reversals and panic selling or buying. No one additional piece of fundamental information could possibly cause every trader’s analytical system to flip or even be available to them simultaneously…. Other than a significant price change.

  9. As Buffet/Graham say: “The market in the short term is a voting machine; in the long term it’s a weighing machine.” If a company is throwing off earnings and cash flow like mad…and earnings have been trending upwards for years or decades; or if a company’s management has taken 4 companies from nothing to millions in the past and are preparing to do it again… but it is not in a sexy industry that the market likes today, for me it’s a buy. I’ll wait for the rest of the world to catch up.

    I combine this type of trading with straight price-action trend following and both do very well…just different time horizons. In fact, when the world “discovers” these undervalued stocks, it’s the trendfollowers who drive up the price to give me better returns. Better late than never for them/us, I guess.

  10. If trading stocks, go with technicals and the best fundys. According to the best growth stock trend follower ever, Wm. O’Neil, “profits are the number one factor in a successful stock”. As long as the market is in an uptrend, and you bought at the proper breakout, go with the best fundys. This gives all fund managers the excuse as to why they bought millions of shares in the first place. It’s these same fund managers (institutional sponsors) who have all the money and control 80% of the market.

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