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Ep. 538: Global Opportunity with Michael Covel on Trend Following Radio

Global Opportunity with Michael Covel on Trend Following Radio
Global Opportunity with Michael Covel on Trend Following Radio

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The vast majority of the investing population only know their own country’s stock index inside their portfolio. Top investors know much more than that. They think about gold, palladium, the Swiss franc, the Japanese yen, silver, copper, bonds, wheat, etc. Most would never think of trading these markets, however these markets are part of the trend following world. Any everyone can trade any market through a handful of different financial instruments such as ETF’s, LEAPS, and futures. The fundamentals of these markets are irrelevant for profit. The only information needed to trade any market for profit is price. This type of thinking opens markets up to anyone and everyone willing to play the game and take advantage of the global opportunity trend following provides.

In this episode of Trend Following Radio:

  • Price action
  • Momentum
  • Macro hedge fund
  • Trade everything
  • Ignoring the fundamentals

“All price action is, is human behavior manifested in the number. That’s it.” – Michael Covel

Listen to this episode:

Trend Following, Momentum, Systematic Quant? Avoid the Mental Masturbation of the “Name” of the Game!

Article seen by Francois Sicart titled “Don’t Get Sidetracked by Momentum Chasing”:

In an early philosophy course, to introduce the concept (and danger) of extrapolation, our professor used the example of an Englishman landing in France for the first time. Seeing two red-headed women on the dock, he immediately calls his friends in London to report that all French women are red heads. The title of a recent Casey Research paper, “Extrapolation Fever”, recently reminded me of this example and its title seemed particularly timely. Extrapolation is the assumption that you can generalize from limited samples and/or that current trends will continue forever. Sadly, we all have a tendency to extrapolate and I have long believed that this is one of the worst biases of investing, responsible for the destruction of innumerable portfolios. This was the reason for my early adoption of a contrarian investment approach. Possibly the second worst investment bias is our need to believe a good story. As a trend matures, its causes become obvious to the average investor. He or she comes to assume that this is the way the world always works, forgetting that by the time a story is obvious to a majority, it is already reflected in the price of a stock or of the market. My view, and that of many contrarian investors, is that the world is cyclical. Economic indicators, for example, tend to fluctuate around either a long-term trend or a historical average, periodically “reverting to the mean”, as statisticians say. Financial markets, which are importantly influenced by the excesses of crowd psychology, do not only revert to the mean, but usually go through it, toward a more “exuberant” high or low. In financial markets, the most common use of extrapolation is called momentum investing, which consists of buying what has been going up on the assumption that it will continue to go up. Numerous studies have documented that momentum investing works most of the time: stocks and markets tend to do as they have been recently doing. The only problem is that many studies also show that (almost by definition) momentum does not work when it counts most, i.e. at major market turning points. And as I have pointed out before, in investments it is not how often you are right that counts; it is how much money you make when you are right. There is no need to revive an old argument about momentum versus value. Let me just say that I personally don’t know any rich momentum investors – at least not any that made and kept a fortune in the stock market. I do know a few rich and successful value contrarian investors, however. There also are some that I have mentioned in the past, whom I do not know but enjoy watching and reading: besides Warren Buffett and Charlie Munger, they include Jeremy Grantham, at GMO.; Howard Marks at Oaktree; and William Browne, of Tweedy, Browne. We not only have a commonality of views, but also similar experiences and career paths. All three gentlemen can also claim superior long-term investment records—and by long-term, I do not mean five year; I mean more than thirty years…There is no lack of successful investors besides those I mentioned above, and my requirement for a thirty-year-plus record may seem self-serving, since only an older investor can have such a record. For example, 56-year-old Seth Klarman, founder of the Baupost Group, has a stellar 25-year record and writes highly stimulating shareholders’ letters, BUT… I will respond like famous Chinese leader Zhou Enlai who, when asked what he thought was the significance of the French Revolution of 1789, reportedly answered: “It is too soon to say”. Today, there is one trend that has been in effect for a very long time and whose causes are well understood and routinely enunciated by even the financially less-literate: declining and low interest rates. Interest rates approached 14% in 1984 and, although recently doubling, have remained under 3% since mid-2011. And, while interest rates declined by 80% almost without interruption for 30 years, the Standard & Poor’s 500 Index gained a remarkable 1041%. Interestingly, I am finding the investor consensus is now overwhelmingly anticipating that interest rates will eventually rise again. So, expecting them to do so is not exactly contrarian. But my concern goes beyond just the stock and bond markets. Thirty years of “suppressed” interest rates, as economists say to describe the central banks’ aggressive role in reducing and almost eliminating financing costs in the economy, must have been addictive. All our instincts and economic reflexes are now unconsciously geared to this misleading environment and, for investors who have no experience pre-dating the early 1980s, it would take an exceptional imagination to picture what it was like to invest in an environment of high and rising inflation, high and rising interest rates. Some of the successful “old guard” may provide some guidance: Jeremy Grantham, in a Barron’s interview in March, believes the stock market may go higher, but for the wrong reasons: We do think the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing until we are in old-fashioned bubble territory and it bursts … But to invest our clients’ money on the basis of speculation being driven by the Fed’s misguided policies doesn’t seem like the best thing to do with our clients’ money… We invest our clients’ money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. Howard Marks, in a lecture at Wharton (March 17, 2014), remembered his early career experiences, which taught him that with its Nifty 50 policy [early 1970s], Citibank had invested in the best companies in America and lost a lot of money; then it invested in the worst companies in America [junk bonds] and made a lot of money. He noted that “it shouldn’t take you too long to figure out that success in investing is not a function of what you buy. It’s a function of what you pay.” An asset of high quality can be overpriced and be a bad investment; an asset of low quality can be bought cheaply and be a good investment. Then focusing on the present, he warned that the current low return on credit instruments, due to low interest rates, has spawned some risky behavior in the market. “If the market is pro-risk, then risky securities can be issued. We have to make sure that it’s not we who buy them.” It would be hard to find a better conclusion than these two quotes, from investors who, over the years, have learned to let wisdom and prudence prevail over greed and short-term competition.

That disproved trend following?

You may also enjoy some of my other Trend Following Podcasts and Articles:

I walk the Line

Vineer Bhansali Podcast

Striving for Excellence

Knowing Your Financial Edge

A Solution to negative interest rates

Momentum is Everywhere…

Recent article on momentum:

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There is a vast body of evidence demonstrating that stock returns exhibit momentum — that is, stocks that have done well over the past year tend to continue to do well. And there’s evidence that the momentum premium exists almost everywhere we look, in both U.S. and international stocks (with the notable exception of Japan). There’s also academic research demonstrating that momentum exists in commodity and foreign exchange markets as well. The authors of the 2012 paper, “Momentum in Government-Bond Markets,” studied the period 1987-2011 to determine if momentum existed in these assets. For six countries — Australia, Canada, Germany, Japan, the U.K., and the U.S — they formed long-short portfolios, going long a particular bond maturity if the excess return of the bonds over cash was positive for the previous month and shorting otherwise. For each country they considered three maturity buckets: 1-3 years, 5-7 years and 7-10 years. They subtracted the LIBOR cash return to arrive at the “excess” return. Rebalancing was done monthly. The strategy is easily implementable using highly liquid futures markets. The benchmark is the currency-hedged Citigroup World Government Bond Index. The following is a summary of their findings:

  • Momentum strategies are profitable, generating annual excess returns over LIBOR of between 0.70 and 2.6 percent, and they do so with low volatility (1 percent to 3.6 percent).
  • Australia, with the least liquid of the six markets studied, exhibited the lowest returns to momentum strategies. The three most liquid markets — U.S., Japan and Germany –are the best for momentum strategies. Thus, greater liquidity doesn’t seem detrimental to momentum strategies (and trading costs are the lowest in the most liquid markets).
  • The strategy doesn’t rely on falling interest rates. However, “choppy” markets without direction are detrimental to performance, and returns can be episodic.
  • The excess profits generated are more than sufficient to cover transactions costs as the government bond markets are very liquid.
  • Momentum returns are particularly strong during periods of poor performance for credit markets. Thus, momentum strategies provide some diversification benefit against bond strategies that seek exposure to credit (default) risk.

The authors tested the diversification benefits by combining a 20 percent momentum strategy with an 80 percent Barclays Capital U.S. Aggregate Bond Index allocation, with monthly rebalancing. The simulated portfolio generated excess returns of 0.35 percent a year while reducing volatility — the standard deviation fell 0.40 percent. Investors who take credit risk in their bond allocations should consider adding a momentum strategy. This diversification benefited provided by momentum strategies also applies to investors in value stocks. Because momentum is negatively correlated with the value premium, adding momentum to a value-tilted portfolio improves risk-adjusted returns. While there is a logical risk-based explanation for the existence of the stock, small-cap and value-stock premiums, there is none for momentum — only a behavioral story. Yet, despite the fact that there is no risk-based explanation and that the existence of momentum has been known for decades (thus it would seem that it should have been arbitraged away), momentum persists virtually everywhere we look.

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Otherwise known as trend following.

The Trend Is Our Friend White Paper

Read The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation. Abstract:

We examine the effectiveness of applying a trend following methodology to global asset allocation between equities,bonds,commodities and real estate.The application of trend following offers a substantial improvement in risk-adjusted performance compared to traditional buy-and-hold portfolios. We also find it to be a superior method of asset allocation than risk parity. Momentum and trend following have often been used interchangeably although the former is a relative concept and the latter absolute. By combining the two we find that one can achieve the higher return levels associated with momentum portfolios but with much reduced volatility and drawdowns due to trend following. We observe that a flexible asset allocation strategy that allocates capital to the best performing instruments irrespective of asset class enhances this further.

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