Trend Following Does Not Involve Prediction

John Thomas, The Mad Hedge Fund Trader, writes:

Fundamental researchers are asserting that at $100 per share in earnings, generating a price earnings multiple of 11.5, stocks are at the historical bottom of a 10-22  range. Q3 earnings are imminent, and will outperform on the upside, although not with the magnitude seen in recent quarters. Plus, QE3 is on the table, and the Federal Reserve may deliver a surprise at its upcoming September 20-21 meeting.

Furthermore, risk assets are about to enter a period of seasonal strength. If you “sell in May and go away”, you should then “return in September and buy.”

No, no, cry the technicians. The S&P 500 is in an ABC corrective pattern. Wave 4 is complete, and the beginning of wave 5 is imminent, crashing the market to new lows. This argument is most clearly elicited by my friend, Arthur Hill, at in the space below. He sees a downside target of 1,025, the July 2010 low.

What is a befuddled individual investor to make of all this? My belief is that fundamentals always win out over the long term, and that technical cues are at best, a lagging indicator. I use technicals for guidelines on where to place orders on a short term basis. The longer you stretch out your time frame, the less relevant they become.

At best, technicals are right 50% of the time, right in the same league as a coin toss. How many technical analysis hedge funds are out there? None. They are all fundamentally driven.

Trend followers are technical traders. How are those left out John? Wow. He continues:

The same technicians making the incredibly bearish prognostications today were making equally convincing bullish arguments in July.

However, since we are descended from prehistoric hunter gatherers, we are all visually oriented. We respond to stimuli we can see much more rapidly than those we can conceive. A picture truly is worth 1,000 words. And probably a lot more. That’s why so many brokerage firms use them to sell research. I employ charts to back up my fundamental arguments because they are so easy to understand, definitely not the other way around.

So I think the fundamentals will eventually win out, and that we will get the autumn rally that I have been predicting. Exactly when will that happen? Don’t ask me. Go ask a technician.

Trend following is not fundamental trading. It is not predictive technical trading. Trend following is technical trading, but it reacts to market moves over trying to predict them. That is a massive distinction. Few seem to see that clearly.

The Author