Monday, March 10, 2014

Discussion on Trend Following, and a Striking Fractal Comparison

At some point in the bull market, virtually everyone will decide that the only type of trading system that "works" is trend following.  Folks will bash systems that try to anticipate the market, and the mantra will finally, irrevocably, become "just buy the fargin' dip, the trend is up."  We may have already reached that point.  Lately I've begun to encounter more and more bashing of predictive systems by trend followers.

What's interesting is that as recently as November 2012, some people were asking if trend following was dead.  This is because trend following is only profitable in certain types of markets; specifically (not to overstate the obvious), it's profitable in trending markets.  But not all markets trend.  Historically, markets alternate between cyclical grinds and periods of trending.

And, needless to say, trends eventually reverse, at which point many trend followers get caught on the wrong side.  (Let me preface here by saying that my intention is not to belittle trend following -- quite the opposite, bear with me a moment.)

To a trader who just started trading in late-2012 or early-2013, trend following will seem like the Holy Grail end-all answer to everything.  But, historically, it actually requires a willingness to endure a high number of losing trades (typically more losers than winners), and requires a great deal of patience.  And by patience, we're talking (at times) enduring months or even years of drawdown.

From 2009 through 2012, many trend following systems struggled, as evidenced by the performance of the hedge funds, which often employ similar systems.  From 2010 through 2012, for example, the S&P 500 (SPX) gained nearly 28% -- but meanwhile the HFRX Equity Hedge Fund Index (a benchmark of the performance of hedge funds) actually lost money over those three years.  Which is why, near the end of 2012, people were asking if trend following was dead.

Of course, as it turned out, this was just when trend following was about to shine again.

The general challenge for traders is that the system which worked best in the recent past may not be the system that works best in the future.  As mentioned, the market cycles over months and years -- and it likes to change things up just when you think you have it all figured out.  These challenges apply for every trading system on the planet, my own included.

New traders tend to expect too much from a system.  This is probably because many new traders decide to begin trading after reading a book, and often it's a book written by someone who tells the story of how they turned $5,000 into $20 million in only 18 seconds (or similar) -- because, let's face it, the books that talk about iron discipline and grinding out small profits over time just don't sell as well.  Those are the books traders start reading after they've lost their shirts attempting to emulate the 18-Second Get Rich Quick Trading System!

But I'm getting ahead of myself.  Back to our new trader:  After reading this get-rich-quick book, the new trader says, "Hey, that sounds easy, and I've got $5000 to invest!  Sure, I probably won't make $20 million in 18 seconds like that author did, but I'd be happy with 10% of that in a month!  Why not give trading a try?"

So they start trading.

Let's imagine they start trading in 2011, and decide to start with a trend following system.  By 2012, they're dead broke, because they didn't realize that $5000 isn't nearly enough of a bankroll to get started.  So in 2012, they reinvest (maybe with their new tax return) and try again -- and they're broke again by 2013.  At this point they decide, "This trend following stuff is garbage."  So they switch systems -- just as trend following starts working.  Which then causes them to miss the big rally of 2013 -- and now they're broke again and they're really frustrated.

2014 rolls around and they decide to switch back to trend following, since it seems to have been working recently.  However, due to their anxiety and frustration (and because they still haven't read the book about discipline), they simply buy the very first little dip that comes along, right at the beginning of 2014.  And, of course, then they get creamed again in the ensuing big sell-off.  If they're like many new traders, they probably further add insult to injury by selling all their long positions at the exact bottom in February and reversing short.  So now they're broke yet again after the recent recovery rally.

Nobody said it was easy.  Well, except for the guy who wanted you to buy his get-rich-quick book.

Personally as a trader/analyst, my goal is not perfection (okay, I'll admit that secretly it is, but I realize that's impossible); my goal is to be correct more often than not -- and, more importantly, to manage risk/reward.  If I manage my risk properly, then the times I'm correct more than offset the times I'm wrong.  And as long as I maintain those two disciplines, I can achieve a positive expectation over time.

In the grand scheme of things, trading isn't about being "right" -- it's about making money.

For me personally, trend following is an important piece of the analytical puzzle.  It's not the end-all to everything -- but neither is anything else, really.  It's no secret that my analysis is often based on anticipation of the market, and some trend followers would frown upon such an approach.  However, when it comes to bottom line, it's hard to find any system that's infallible.  Most honest analysts would be forced to agree that, whatever their particular system: sometimes it works quite well; other times, it doesn't.

And the broader point is this:  the market has a way of humbling the proud.  If you're feeling invincible in your trading system lately, stay aware that the market is warming up a brand new pitcher in the bullpen (or "bearpen," as the case sometimes is), and he's getting ready to throw you a pitch you've never seen before.  No one has figured out the perfect trading system (or, if they have, they certainly aren't sharing it with anyone!).

While Elliott Wave is no more perfect than any other system, one of the many things I appreciate about Elliott Wave is its ability to quantify the market's cycles through market psychology.  We can gain insight into why all systems fail at times by understanding the wave cycles:

First and second waves exist to foil trend followers:  The first wave of the new trend is assumed to be a correction to the old trend, and the second wave is then assumed to be a resumption of the old trend.  In reality, the second wave is the first correction of the new trend (read that all again if you need to) -- but few recognize that yet, so the majority are positioning the exact reverse of how they should.  Trend followers get stopped out and/or reverse as the third wave hits and defines the new trend.

Third waves can be profitable for everyone -- and they are especially profitable for folks who stick with the trend (this is where we've been in the market recently: a third wave).  Third waves are, in fact, what trend followers are waiting for (whether they characterize them as such or not).  As an Elliottician, third waves are what I trade for too, and where the meat of my profits are made.  As far as I can tell, one of the main differences is I try to position correctly in advance of the third wave.  Yes, you read that right:  I sometimes try to predict the market!  Do I get them all right?  Absolutely not.  As noted earlier, the key is risk management.  And as just one example of how well anticipation/prediction can work:  On July 8, 2013, I suggested Apple (AAPL) as a long play (it was trading in the very low-400's -- See: SPX and Apple: Apple's Worth Taking a Look at Again), with a preferred target of 510-530 (recall that this was well-before Icahn and Soros moved AAPL by announcing their long positions).  That trade was one of the most profitable of 2013 for me, and it was anticipatory and predictive -- against the intermediate trend.  In my view, bashing predictive systems when they fail makes no more sense than asking if trend following is "dead" when it fails.  Everything fails at times.   
Fourth waves exist to foil everyone, but ultimately, they are profitable to those who stay nimble over the near term, and who stay on the right side of the larger trend over the longer term.  For position traders, some drawdown must be endured during fourth waves, regardless of the system employed -- but in the end, the fifth wave comes along and makes the position good.  The problem is...

Fifth waves exist to suck in new trend chasers.  The fifth wave rally (or decline) is, in fact, almost solely driven by folks who are showing up late to the party.  The smart money begins distributing their positions to these newcomers, who don't realize that most, if not all (or more!), of the profits gained during an average fifth wave will subsequently be lost during the ensuing turn.

Return to start -- but now add this to the mix:  For those who are too slow to respond to the trend change after the fifth wave, the third wave will wipe them out.

I think the key with predictive systems is to understand their limitations and not get too far ahead of the market.  There's a temptation with predictive systems to overreach.  In fact, certain well-known predictive services have all but wiped out their subscribers by overreaching and trying to anticipate the market years in advance against the prevailing trend.  If one approaches market prediction with the idea that they can see so far down the road, with such amazing clarity, that they don't even need to adjust and respond to changing real-time conditions, then they're ultimately doomed to failure.

But they will not fail due to their system -- they will fail due to their arrogance.

Anyway, for those interested in trend following, here's a starting place, via an indicator I've published previously.  I believe trend following is a powerful tool that one should add to their trading arsenal -- of course, you'll have to decide personally to what degree you wish to employ it (assuming you don't already).

Next is the current S&P 500 (SPX) chart, which is materially unchanged since March 5, though I've added a few signals and levels to watch.  The market has traded in a narrow price range for about a week, and remains paused at the current inflection point.  I suspect we've chewed up enough time and price here that the market will break away from this range in short order.  Do note the market could stretch wave (5) a little higher here without creating any issues for the bear count: As mentioned previously, if we see sustained trade north of 1895, then we'll start to suspect bulls have found a second wind.

Finally (as far as I know, anyway) this next chart is wholly original.  I'm actually a little surprised I didn't spot this analog sooner:  The fractal similarity between the current bull market (linear scale) and the long-term SPX chart (log scale) is somewhat remarkable.  Note the very long-term chart I'm using ends in 2008 -- I used it anyway because it was the right scale and we all know what happens in the missing portion of the chart.

Incidentally, the 1929 analog so many were tracking went off course -- possibly because too many people were aware of it. 

The most interesting part about the fractal below is that the wave counts are basically the same.  On the very long-term chart, the massive bull market at the end of the 20th century was an extended fifth wave of Supercycle Wave III.  The current market is assumed to be in the fifth wave of Intermediate Wave III.  If the current market extends this fifth wave, it could make a similar move as the very long-term chart (relative, of course).  However, if the current market's fifth does not extend, then there are already enough waves in place for a large fourth wave correction to begin (the bear market of 2000-2009 was Supercycle Wave IV).

In conclusion, SPX remains paused at the inflection point I've discussed over the past week.  Inflection points are not, of course, "guaranteed" reversal zones; they are zones where trend reversals have higher odds of occurring.  Bears still have a solid shot at generating such a reversal here, so stay nimble -- and trade safe.

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