Tasting Notes About Momentum

Momentum & Trend Following Notes

“Even in the future, the sweet isn’t as sweet without the sour.”

— film Vanilla Sky

Since I started Rooster360 to share my evolution as a speculator, I provided hundreds of charts and focused on price-focused speculation. I had a process which produced some pretty nifty returns and I thought naively that is all readers needed to see. I offered a taste of the profits but not enough about the bitterness involved to consume such sweet results.

I noticed readers’ fixation over profits but very little discussion about process. Their focus was about what to trade, and when to do so, but very little about how and why. They always thought Mr. Market’s menu was always the same and all they had to do was order from one item from each column, then dessert, and that the check would be the same each time.

If Mr. Market was truly a dining establishment of fixed nature, offering a predictable experience then maybe diners could get away with just “what” and “when” — but he is neurotic, quixotic and a bit manic. Mr. Market is volatile and changes his mind from moment to moment and there’s no telling what will come, sweet, sour or down-right bitter, or just how big the bill will be.

Do you have the risk-palate for Mr. Market’s changing tastes?

I’m not just talking a company which “missed a quarter” or “guided down” — we’re talking also about profound transformations. Today’s winner is tomorrow’s bankruptcy. Today’s busted bond becomes tomorrow’s new re-discovered stock. A distressed industry/sector today becomes an outperforming asset class next year. High prices, cured by high prices, then become shorts and low prices, cured low prices, gives birth to life-changing ”ten (or more) baggers”.

All markets change and they cannot be predicted. Only a fool would agree to having a gun to their head, betting his/her life on a specific prediction about the future. And yet people commit financial suicide constantly with far less conviction because they’re betting bucks not bullets. There is no need for that. There is a process of managing uncertainty, change, with less angst and ennui over specific outcomes.*

*(Those who are insider active majority/control investors might be less concerned since their game includes capital structure/balance sheet/event-driven approaches. They feast on a different diet of risk-taking.)

I’m about to dig into the subject of “trend following”: the speculative process of following price and managing risk. Pretty soon, however, someone might think all you need is a specific “formula”. That is conceptually just a few floors above the sub-basement of picking investment “holy grails”. People have a deep-seated need for a “secret sauce” as if there was an incantation we could master to unlock hidden treasures. Sadly, captives of such magical thinking tend to conjure messy models of bad behavior as their reward.

Recently however, the academic embrace of “trend following” and “behavioral economics” has chipped away at two pillars of “conventional” market thinking: the abstract strictures of “rational markets” and our amorphous but very substantial cognitive and emotional biases. Many speculators trapped between what was academic dogma about logical economic behavior and their own unresolved issues rooted in their inner lives.

I’m going to share some readings, quotes and links to interesting sources on the subject of trend-following - termed by some as “momentum investing”. The problem with words is they can be interpreted with a lot of loaded meaning, much like how our palates taste the same food but we all come away with differing personal reactions. One trader’s “bitter” dish comes off as “mild”, another reacts to something as sweet but another finds it bland. Here are my tasting notes about this subject but you make your own judgments.

And now for quotes and links to some cool and relevant tasty content.

I absolutely love reading Shane Parrish and his food for thought blog, the great Farnam Street Blog. It’s meaty food for the mind.

In Parrish’s post, “Mental Model: Misconceptions of Chance”, we see some of the handicaps we operate with, and that come from within or are shared via herd and conventional behavior, when it comes to independent events:

“We expect the immediate outcome of events to represent the broader outcomes expected from a large number of trials. We believe that chance events will immediately self-correct and that small sample sizes are representative of the populations from which they are drawn. All of these beliefs lead us astray.”

Sample size is a real issue we don’t quantify in our thinking. This is not the kind of thing we do like breathing. We can throw a baseball, kick a soccer ball, swing a golf club without having to do the “math” first but this does not translate into other parts of life, like trading.

Parrish, quoting Peter Bevelin of Seeking Wisdom: “We tend to believe that the probability of an independent event is lowered when it has happened recently or that the probability is increased when it hasn’t happened recently.

Another pitfall cited by Parrish: “Daniel Kahneman coined the term misconceptions of chance to describe the phenomenon of people extrapolating large-scale patterns to samples of a much smaller size.”

“There is a specific variation of the misconceptions of chance that Kahneman calls the Gambler’s fallacy (elsewhere also called the Monte Carlo fallacy). The gambler’s fallacy implies that when we come across a local imbalance, we expect that the future events will smoothen it out. We will act as if every segment of the random sequence must reflect the true proportion and, if the sequence has deviated from the population proportion, we expect the imbalance to soon be corrected.”

Parrish, quoting Kahneman: “The heart of the gambler’s fallacy is a misconception of the fairness of the laws of chance.

This is a starting point on behavioral economics. There is much more at the Farnam Street blog. Please check it out.

Let’s jump to Why Momentum Investing Works by a great market mind, Ben Carlson, who runs the “A Wealth of Common Sense” blog.

Carlson, during a Q&A exchange with Patrick O’Shaughnessy, observed, “I’m a huge fan of the momentum factor, mainly for its diversification benefits. It’s also the least understood of the well-known risk factors. I’ve done a ton of work on momentum in my day job, but haven’t been too impressed with the retail products available. Most cost too much or they’re not tax efficient because it’s a higher turnover strategy.”

So momentum has merits but the “products” out there are more made for selling it seems.

Carlson’s definition of momentum is straight-forward: “So what exactly is momentum? In short, momentum is the fact that markets tend to continue to trend in the direction they’re going much longer than most people assume is possible. Investments that have performed well tend to continue to perform well and investments that have performed poorly tend to continue to perform poorly.”

Carlson digs into the heart of many people’s problem with momentum: “It’s also counter-intuitive to almost every other strategy out there, which can make investors uncomfortable if they don’t know what they’re doing.”

I love Carlson’s precise comparison between “value” and “momentum”:

“Value investing is based on a long-term reversion to the mean. Momentum investing is based on that gap in time that exists before mean reversion occurs. Value is a long game, while momentum is usually seen in the short- to intermediate-term.”

(This might be known as “absolute momentum” or “time series momentum”.)

Carlson’s twitter handle is @awealthofcs and he covers a wide variety of subjects with honesty and clarity. Please consider him a “must read” or “must follow” if you don’t already follow him or read his blog.

Next up is a discussion from another heavy-hitter, AQR Capital Management, which released a paper called, “A Century of Evidence on Trend-Following Investing“:

Their executive summary begins with: “We study the performance of trend-following investing across global markets since 1903, extending the existing evidence by more than 80 years.”

OK, let’s just say they really dug into the subject of “trend following”.

They observe: “The most basic trend-following strategy is time series momentum — going long markets with recent positive returns and shorting those with recent negative returns. Time series momentum has been profitable on average since 1985 for nearly all equity index futures, fixed income futures, commodity futures, and currency forwards.”

BEFORE you jump back with “what about all that stuff about Kahneman and SMALL SAMPLE SIZE you threw at us a few paragraphs earlier?”

AQR said the objective of the paper: “seeks to establish whether the strong performance of trend-following is a statistical fluke of the last few decades or a more robust phenomenon that exists over a wide range of economic conditions. Using historical data from a number of sources, we construct a time series momentum strategy all the way back to 1903 and find that the strategy has been consistently profitable throughout the past 110 years.

HOW they did it: “Specifically, we construct an equal- weighted combination of 1-month, 3-month, and 12-month time series momentum strategies for 59 markets across 4 major asset classes — 24 commodities, 11 equity indices, 15 bond markets, and 9 currency pairs — from January 1903 to June 2012. Since not all markets have return data going back to 1903, we construct the strategies using the largest number of assets for which return data exist at each point in time.” AND they INCLUDED costs of a “2-and-20” nature that hedge funds have been using. (2% of assets and 20% of profits) in their studies in case you were wondering.

I want you to read the paper, but the “tldr” for the non-math folks is: “Trends appear to be a pervasive characteristic of speculative financial markets over the long term.”

In case you’re saying “well that’s great in a bull market when things go up, then what if things go wrong and go down?” AQR has this answer: “Why have trend-following strategies tended to do well in bear markets? The intuition is that the majority of bear markets have historically occurred gradually over several months, rather than abruptly over a few days, which allows trend-followers an opportunity to position themselves short after the initial market decline and profit from continued market declines. In fact, the average peak-to-trough drawdown length of the ten largest 60/40 drawdowns between 1903 and 2012 was approximately 18 months.”

The study observed and concluded that while this method waxes and wanes it’s a part of what work does work in financial markets.

AQR has more to contribute, this time via co-founder Cliff Asness, as one of the co-authors of a very nice paper from May 2014, entitled “Fact, Fiction and Momentum Investing”, which noted: “The return premium is evident in 212 years (yes, this is not a typo, two hundred and twelve years of data from 1801 to 2012).” Here, Asness and company go on to bust 10 “myths” about momentum, propagated by cheerleaders for the orthodoxy of rational markets.

I include the following anti-momentum myth busted by Asness, for those of you with “tax efficiency” on your mind: “momentum, despite having five to six times the annual turnover as value, actually has a similar tax burden as value. At first blush this seems counter-intuitive, until you realize the following two facts. First, momentum actually has turnover that is biased to be tax advantageous — it tends to hold on to winners and sell losers — thus avoiding realizing short-term capital gains in favor of long-term capital gains and realizing short-term capital losses. From a tax perspective this is efficient.”

Asness and AQR are not alone in their findings. Some interesting content, from Newfound Research, founded in 2008:

Two Centuries of Momentum

“In 1838, James Grant published The Great Metropolis, Volume 2. Within, he spoke of David Ricardo, an English political economist who was active in the London markets in the late 1700s and early 1800s. Ricardo amassed a large fortune trading both bonds and stocks.”

Newfound Research, quoting Grant:

“Ricardo’s success was attributed to three golden rules:

As I have mentioned the name of Mr. Ricardo, I may observe that he amassed his immense fortune by a scrupulous attention to what he called his own three golden rules, the observance of which he used to press on his private friends. These were, “Never refuse an option* when you can get it,” — ”Cut short your losses,” — ”Let your profits run on.” By cutting short one’s losses, Mr. Ricardo meant that when a member had made a purchase of stock, and prices were falling, he ought to sell immediately. And by letting one’s profits “run on” he meant, that when a member possessed stock, and prices were raising, he ought not to sell until prices had reached their highest andthen were beginning again to fall*. As for never refusing an option, I would begin to think about the idea of trend-following overlaps with being long “fat-tail” optionality. These are, indeed, golden rules, and may be applied with advantage to innumerable other transactions than those connected with the Stock Exchange.”

(*This is easier said than done but there are many traders who build systems with rules defining this condition, including me — “know when to fold ‘em”.)

Newfound Research further related recent history of other market successes. They mentioned trader Jesse Livermore, known to many who studied financial market history and lore. Most readers, however, won’t know about Jack Dreyfus. All that remains of Dreyfus is a name for many market students, but he was a successful money manager who took full advantage of following price:

“[D]uring the 1950s and 1960s was Jack Dreyfus, who Barron’s named the second most significant money manager of the last century. From 1953 to 1964, his Dreyfus Fund returned 604% compared to 346% for the Dow index. Studies performed by William O’Neil showed that Dreyfus tended to buy stocks making new 52-week highs. It wouldn’t be until 2004 that academic studies would confirm this method of investing.”

Newfound Research also shared research from decades ago on time-series momentum and trend following:

“In 1933, Alfred Cowles III and Herbert Jones released a research paper titled Some A Posteriori Probabilities in Stock Market Action. Within it they specifically focused on “inertia” at the “microscopic” — or stock — level. They focused on counting the ratio of sequences, times when positive returns were followed by positive returns, or negative returns were followed by negative returns, to reversals [A/K/A when a price trend ended / reversed]… It was found that, for every series with intervals between observations of from 20 minutes up to and including 3 years, the sequences out-numbered the reversals.”

Newfound goes on to cover the history of academic research which eclipsed momentum investing research. This was an era which began to crack in the 1990s, when the giants of rational market research, Eugene Fama and Kenneth French, examined the ever present factor of returns from momentum investing and could not explain away this apparent “embarrassment”. The research which followed Fama & French’s 1996 research paper, “Multifactor Explanation of Asset Pricing Anomalies”, seemed to do little to remove momentum. Newfound cites papers about momentum’s success in country indices, international equities, mutual funds and foreign exchange, developed economies, commodity futures AND spot prices, emerging markets, non-investment grade corporate bonds and liquid fixed income assets. (This is not a complete list, there is more from Newfound available.) One paper from 2003, observed momentum’s success to be “large and statistically reliable in periods of both negative and positive economic growth” without unique macroeconomic or risk-based explanations to momentum returns.

What does this mean for Rooster360? My profitable feast of “Price Following” is like an expedition through a dense jungle in search of a rare and highly prized fruit: massively profitable moments which pays for the expedition. There is a backpack of supplies, our capital and related resources, and a rough map of the terrain, our system of rules. But the map presents a “10,000 foot” view of the terrain -which is prone to constantly changing extremes of weather. The future makes for constantly changing conditions on the ground. The path through these wilds includes the risk of ravines ahead and steep sharp-angled switchbacks — but the hike is done slowly, giving time to scramble through it or divert— this is not a race. Rooster360 is about staying alive to make it to each rest stop and finding some special fruit. Some bitterness along the way is part of the price of discovering great sweetness.

Originally published at www.rooster360.com on August 16, 2015.