Please enjoy my monologue Everyone Needs a Trading System to Profit with Michael Covel on Trend Following Radio. This episode may also include great outside guests from my archive.
In this episode of Trend Following Radio:
Human nature doesn’t change
Timelessness
Behavioral finance
Sticking with a system
Risk management
Bill Dunn on trend following
“Find the wizard behind the right curtain and you have a chance.” – Michael Covel
“The system protects you from being human.” – Howard Lindzon
Perhaps not surprising, trend followers have spent as much time observing and understanding human behavior as they have trading. Understanding human behavior and how it relates with markets is commonly referred to as behavioral finance.
Behavioral finance evolved out of a contradiction between classical economic theory and reality. Economic theory is based on the assumption that people act rationally, have identical values and access to information, and use rational decision making. The truth is people are irrational and seldom make completely rational decisions even if they think they do. I have had the good fortune to learn from some of the top minds in the field of behavioral finance. From Nobel Prize winner Vernon Smith to Charles Faulkner, my eyes have been opened. Faulkner outlined the core issues:
“The current proliferation of electronic technologies— computers, the Internet, cell phones, 24-hour news, and instant analysis—tend to distract us from the essentially human nature of markets. Greed, hope, fear, and denial, herd behavior, impulsiveness, and impatience with process (‘Are we there yet?’) are still around, and if anything, more intensely so. Few people have absorbed the hard neuroscience research that reasons arrive afterwards. That given the choice between a simple, easy-to-understand explanation that works and a difficult one that doesn’t, people tend to pick the latter. People would rather have any story about how a series of price changes happened than that there is no rational reason for it. Confusing hindsight with foresight and complexity with insight are a few more ‘cognitive illusions’ of Behavioral Finance.”
Faulkner is correct, but that doesn’t make his words easy. The problem is that by not accepting that truth, you will get into trouble one way or another, as Carl Sagan reminds us:
“It is far better to grasp the universe as it really is than to persist in delusion, however satisfying and reassuring.”
A few years after writing Trend Following I came across another great mind in the field of human behavior and psychology, Alan Watts. Consider some feedback from a listener:
Mike,
Thanks for turning me on to Alan Watts through your podcasts. Below is a link to an audiobook that I think you may find interesting, considering your interests in yoga and other eastern traditions. Andrew is a Lama (not a llama) and an old friend of mine: Here
On today’s episode of Trend Following Radio Michael Covel interviews Emil van Essen. Michael first heard of Emil from former turtle, Lucy Wyatt. The first thing to note is that he is not a trend following trader. He is a commodity spread trader. Emil has been a CTA since 1997, but his first trading experience was at the early age of 12. Emil delivered papers when he was younger and would take the money and invest in rare coins. The owner of the coin store happened to be a commodity trader. He helped teach Emil about trading commodities and even put in trades for him. Emil’s first trading job was in 1986 at the age of 21.
Michael and Emil start the podcast explaining spread trading. Emil describes trend following as one dimensional whereas spread trading in his view has a multidimensional trading surface because of all the directions a trade can profit rather than if the market only goes up or down. Emil refers to his trading as not systematic but model driven. At the base of his every trade is a model and they can tweak the model accordingly as they see fit–a big distinction compared to trend following.
Emil’s firm is one of the only CTA’s that are negatively correlated to trend followers. He also believes that following rules 100% of the time is a bad idea. “Our brains are far more smarter than computers,” he states. Emil adds, “We need to know not to be emotional about trades but if you don’t adapt to change then you won’t last.” Emil also throws around the controversial word, “prediction.” He says that when he says “predication”, it is actually more about “probability.” He tries to find a method that reliably tells him that something is going to happen more often than not. Emil says, “You try and find an edge. Find consistent behavior patterns that give you a risk adjusted return.”
In this episode of Trend Following Radio:
Growth of commodity ETFs
Diversification
Raising money vs. Making money
Quality Investors vs. Quantity of Investors
Beta and Alpha
Not all investors are created equal
“Long only commodities is the gateway drug into commodities.” –Emil van Essen
“If your trend trading you are always capturing that extreme volatility, whereas if you are spread trading you are sometimes the victim of that volatility and if you are not well diversified then you have a problem.” –Emil van Essen
It is amazing how quick people are to forget how wrong one prediction is, only to move onto believing in another prediction. An excerpt from the chapter “Intoxication”, in Trend Commandments:
A bipolar prediction came across my desk recently: “If the market rises over the next several weeks, today will have been a good day to buy. However, no one can know the answer today. Every day there seems to be a surprise. We don’t know how to predict the behavior of foreign countries or their attacks.”
The nonsense doesn’t stop there. While on the East Coast recently, I was listening to an AM radio finance show. An older man called in to ask how he could buy into various commodity markets. He was worried that they had run too far already. The female host assured him that there was plenty of time and to jump into the market. The caller mentioned that he liked to buy low and was waiting for a pullback. The host told him to start preparing for hyperinflation. She named an African country to enhance her theory and leaned the conversation toward food insurance, needed of course for the coming descent into anarchy.
Think not knowing what you are talking about is new? Think again. President Herbert Hoover circa May 1930: “While the crash only took place six months ago, I am convinced we have now passed through the worst—and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us.” Can’t just pick on old-timers. Consider the current day. Lloyd Blankfein (head of Goldman Sachs) said his firm would have survived the credit crisis without government help. The firm’s president, Gary Cohn, was more definitive: “I think we would not have failed. We had cash.” Treasury Secretary Timothy Geithner countered, “None of them would have survived” without government help.
More contradicting rhetoric from a 2010 60 Minutes interview reinforces the propaganda spell cast:
Scott Pelley: “Is keeping inflation in check less of a priority for the Federal Reserve now?”
Ben Bernanke: “No, absolutely not. What we’re trying to do is achieve a balance. We’ve been very, very clear that we will not allow inflation to rise above two percent or less.”
Pelley: “Can you act quickly enough to prevent inflation from getting out of control?”
Bernanke: “We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time. Now, that time is not now.”
Pelley: “You have what degree of confidence in your ability to control this?”
Bernanke: “One hundred percent.”
That confidence seems misplaced when you consider Bernanke’s words but a few years before:
In 2005, Bernanke said: “We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.”4 In 2006, Bernanke said: “Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.”
In 2007, Bernanke stated: “At this juncture…the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.”
Worse yet? Bernanke told the Senate Banking Committee in March 2011 that he saw “little evidence” that the stock market was a bubble, but provided certainty with this ditty of a response: “Of course, nobody can know for sure.” Why again do we care what this man says?
Not only can the pros not understand the data, but the conclusions they draw are almost always wrong.
Feedback in that adds to my thought:
Hi Mike, thought you might enjoy these. I listen to some of the BBC “More or less” podcasts, found this one (spurious correlations) when scrolling through their archives. So many out there (not just in finance) tend to torture data to find what supports their bias. The podcast and site do a good job at poking some fun at those tendencies.
Tell me something the “market” does not know. The idea that you can know enough about Apple, oil, GE, and gold to trade them all the same way may seem preposterous, but think about what they all have in common: Price.
Market price is objective data. You can look at individual price histories, without knowing which market is which, and still trade all successfully. That is not what they teach at Harvard, Wharton, Kellogg, Stern, Darden, or pick your favorite business school du jour.
However, the concept of price as the critical trading cue may be too simple for mass acceptance. For example, a prominent business anchor opined: “At some point, investing is an act of faith. If you can’t believe the numbers, annual reports, etc., what numbers can you believe?” A longtime financial reporter at Fortune magazine was also on the highway going the wrong direction: “If some of the smartest people on Wall Street can’t trust the numbers, you wonder who can trust the numbers.”
You can never trust those numbers—that is, the reported firm details—completely. Someone can always alter them (remember Enron had a fake trading floor). Beyond that, even if you know accurate balance sheet numbers, how does this help you determine when or how much to buy or sell?
The market is always right, and price is the only true reality in trading. If you want to make money in any market, you need to mirror what the market is doing. If the market is going down and you are long, the market is right and you are wrong. If the market is going up and you are short, the market is right and you are wrong. Other things being equal, the longer you stay right with the market, the more money you will make. The longer you stay wrong with the market, the more money you will lose.
You do not need to know anything about bonds. You do not need to understand different currencies. They are just numbers. Corn is a little different than bonds, but not different enough to trade them differently. Some people have a different system for each market. That is absurd. You are trading mob psychology. You are not trading corn, soybeans, or S&P’s. You are merely trading numbers.
Some feedback from a listener on price:
Dear Michael, I think that you have done a great work in explaining what trend following is. However, there are two great arguments that you have never faced:
1. You have always discussed price. I know that prices constitute a trend. Nevertheless, you should interview some of the main traders that [use] volumes. I would like to know how great traders interpret volumes as they are the first step for an incoming new trend. This study is lacking in all your work. It would be very helpful to know anything about that.
2. You have always talked about trends. It is correct. However, it is better to buy a stock that is likely to have a +200% uptrend than a stock that is only likely to have a +20% uptrend. So the questions is: how do great trend follower traders make their picks by relying their choice ONLY on prices and volumes?
I will wait for a polite answer of yours.
Kind regards,
[Name]
You can’t predict the next 20% v. 200% move. Impossible.
Volume? That is not the main topic of conversation in my trend following world.
Please enjoy my monologue Earl Weaver, the Baltimore Orioles and the Power of the 3-Run Home Run with Michael Covel on Trend Following Radio. This episode may also include great outside guests from my archive.
In this episode of Trend Following Radio:
Trend following as a numbers game
Earl Weaver’s Moneyball legacy
Why homeruns pay for the losses
Consistency as an illusion
Trading is/as a game
Know your strategy and stick with it
“Your most precious possessions on offense are your 27 outs.” –Earl Weaver
Consider a chapter titled “Convert” from one of my latest books, Trend Commandments:
Over the years, my firm’s trend following research work has put me in contact with thousands of investors and traders spread across more than 100 countries. That was never expected with the simple launch of a five-page web site in late 1996 titled TurtleTrader®. Back then I paid a 22-year old programmer $4,000 for that bit of web design. He quickly disappeared back to Russia, and I became a self-taught HTML coder.
Today, out of that humble beginning, there is no one type of person who reaches out for trend trading insight. Readers and clients include men and women, young and old, from college students to billion-dollar hedge funds. My sites have become a central clearing for all that is systematic trend following trading.
One of the most interesting aspects of spreading this gospel is conversion. People who once viewed trading one way, but who were influenced to change via my work. An example? A new client signed on recently. He has a very popular national radio show and has been working with private clients for decades. His specialty? Putting his clients’ money to work using fundamental analysis. How much trend trading experience did he have prior to my books? None that I am aware. My research firm helped him to move in the right direction, but that was not what especially struck me in this case.
He was very open in telling me why he became a client. There was one basic reason: After the market bottomed in Spring 2009, he saw no fundamental reason for equity markets to trend up, but they did. He decided at that moment, and in the context of seeing my books, that he needed new tools to deal with that clear discrepancy as soon as possible.
Our conversation and exchanges were inspiring. After decades of providing a service to his clients, he knew something was wrong. He understood that he had to make an adjustment in his business. Not many people do that. Many are like the arrogant professors at the University of Chicago believing markets are efficient, people are rational, and it’s my way or the highway. Don’t be like the professors. Be a sponge. Be open to the new.
