How to Survive in This Economy

Do you consider yourself an investor or a trader? Most people think of themselves as investors. However, if you knew that the biggest winners in the markets call themselves traders, wouldn’t you want to know why? Simply put, they don’t invest; they trade.

Investors put their money, or capital, into a market, such as stocks or real estate, under the assumption that the value will always increase over time. As the value increases, so does the person’s "investment." Investors typically do not have a plan for when their investment value decreases. They usually hold on to their investment, hoping that the value will reverse itself and go back up. Investors typically succeed in bull markets and lose in bear markets.

This is because investors anticipate bear markets with fear and trepidation, and therefore, they are unable to plan how to respond when they start to lose. They choose to "hang tight," and they continue to lose. They have an idea that a different approach to their losing involves more complicated trading techniques such as "selling short," of which they know little and don’t care to learn. If the mainstream press continually positions investing as "good" or "safe" and trading as "bad" or "risky," people are reluctant to align themselves with traders or even seek to understand what trading is about.

A trader has a defined plan or strategy to put capital into a market to achieve a single goal: profit. Traders don’t care what they own or what they sell as long as they end up with more money than they started with. They are not investing in anything. They are trading. It is a critical distinction.

Tom Basso, a longtime trader, has said that a person is a trader whether or not he is actually trading. Some people think they must be in and out of the markets every day to call themselves traders. What makes someone a trader has more to do with his perspective on life more so than making a given trade. For example, a great trader’s perspective includes extreme patience. Like the African lion waiting for days for the right moment to strike its unsuspecting prey, a trend follower can wait weeks or months for the right trade that puts the odds on his side.

Additionally, and ideally, traders go short as often as they go long, enabling them to make money in both up and down markets. However, a majority of traders won’t or can’t go short. They struggle with the concept of making money when a market declines. I hope that after reading Trend Following, the confusion and hesitation associated with making money in down markets, markets that are dropping or crashing, will dissipate.

There are two basic theories that are used to trade in the markets. The first theory is fundamental analysis. It is the study of external factors that affect the supply and demand of a particular market. Fundamental analysis uses factors such as weather, government policy, domestic and foreign political and economic events, price-earnings ratios, and balance sheets to make buy and sell decisions. By monitoring "fundamentals" for a particular market, one can supposedly predict a change in market direction before that change has been reflected in the price of the market with the belief that you can then make money from that knowledge.

The vast majority of Wall Street uses fundamental analysis alone. They are the academics, brokers, and analysts who spoke highly of the new economy during the dot-com craze. These same Wall Street players brought millions of players into the real estate and credit bubbles of 2008. Millions bought into their rosy fundamental projections and rode bubbles straight up with no clue how to exit when those bubbles finally burst. Consider an exchange between a questioner and President Bush at a December 17, 2007 press conference:

Questioner: "I wanted to ask you [Mr. President][md]I’m a financial advisor here in Fredericksburg [Virginia], and I wanted to ask you what your thoughts are on the market going forward for ’08, and if any of your policies would make any difference?"

The President: "No (laughter), I’m not going to answer your question. If I were an investor, I would be looking at the basic fundamentals of the economy. Early on in my presidency, somebody asked me about the stock market, and I thought I was a financial genius, and it was a mistake (laughter). The fundamentals of this nation are strong. One of the interesting developments has been the role of exports in overall GDP growth. When you open up markets for goods and services, and we’re treated fairly, we can compete just about with anybody, anywhere. And exports have been an integral part, at least of the 3rd quarter growth. But far be it for me – I apologize – for not being in the position to answer your question. But I don’t think you want your President opining on whether the Dow Jones is going to (laughter) be going up or down."

The President’s view is a typical fundamental view shared by the vast majority of market participants. Consider further an excerpt found in Yahoo! Finance’s commentary; it outlines a single market day:

"It started off decent, but ended up the fourth straight down day for stocks early on, the indices were in the green, mostly as a continuation from the bounce Monday afternoon, but as the day wore on and the markets failed to show any upward momentum, the breakdown finally occurred. The impetus this time was attributed to the weakness in the dollar, even though the dollar was down early in the day while stocks were up also, oil prices popped higher on wishful thinking statements from a Venezuelan official about OPEC cutting production whether or not these factors were simply excuses for selling, or truly perceived as fundamental factors hardly matters."

Millions of readers read this type of drivel every day. Worse, thousands watch Jim Cramer of Mad Money fame promote similar nonsensical beliefs every day. Predictions based off of fundamental analysis don’t work for the vast majority of market participants. Great example? Not many predicted the October/November 2008 market crash! On top of not being able to predict, fundamental analysis leaves many with trying to pick bottoms or trust that conditions will always improve. One of the great traders of the twentieth century, Ed Seykota, nailed the problem with fundamental analysis:

"One evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife off the edge of the table. He watched the knife twirl through the air, as it came to rest with the pointed end sticking into his shoe. ‘Why didn’t you move your foot?’ I exclaimed. ‘I was waiting for it to come back up,’ he replied."

Don’t we all know an investor who is waiting for "his" market to come back? The financial website marketer Motley Fool has a back-story, a narrative behind how it started, that reflects the folly of literally banking on fundamental analysis as a solution for making money:

"It all started with chocolate pudding. When they were young, brothers David and Tom Gardner learned about stocks and the business world from their father at the supermarket. Dad, a lawyer and economist, would tell them, ‘See that pudding? We own the company that makes it! Every time someone buys that pudding, it’s good for our company. So go get some more!’ The lesson stuck."

The Motley Fools’ David and Tom Gardner’s pudding story might be cute, but it is Forrest Gump-like simplistic (and wrong). Their plan gets you in, but it doesn’t tell you when to get out or how much of the pudding stock you must buy. Unfortunately, many people believe that simple story is a good strategy for making money. That is a sad state of affairs.

A second market theory, technical analysis, operates in stark contrast to fundamental analysis. This approach is based on the belief that at any given point in time market prices reflect all known factors affecting supply and demand for that particular market. Instead of evaluating fundamental factors, technical analysis looks at the market prices themselves. Technical traders believe that a careful analysis of daily price action is an effective means of trading for profit.

Now here is where an understanding of technical analysis becomes complicated. There are essentially two forms of technical analysis. One form is based on an ability to "read" charts and use "indicators" to predict market direction. Here is an example of the mentality behind a predictive view of technical analysis:

"I often hear people swear they make money with technical analysis. Do they really? The answer, of course, is that they do. People make money using all sorts of strategies, including some involving tea leaves and sunspots. The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Most academic financial experts believe in some form of the random-walk theory and consider technical analysis almost indistinguishable from a pseudoscience whose predictions are either worthless or, at best, so barely discernibly better than chance as to be unexploitable because of transaction costs."

This is the view of technical analysis held by most people who know of technical analysis that it is some form of mysterious chart reading technique, such as astrology. Equity research from a major bank furthers my prediction distinction point:

"The question of whether technical analysis works has been a topic of contention for over three decades. Can past prices forecast future performance?"

However, there is another type of technical analysis that neither tries to predict or forecast. This type is based on reacting to price action. Trend followers are the group of technical traders who use reactive technical analysis. Instead of trying to predict a market direction, their strategy is to react to the market’s movements whenever they occur. This enables them to focus on the market’s actual moves and not get emotionally involved with trying to predict direction or duration.

That said, this type of price analysis never allows trend followers to enter at the exact bottom of a trend or exit at the exact top of the trend. Second, with price analysis, they don’t necessarily trade every day. Instead, trend followers wait patiently for the right market conditions instead of forcing the market. Third, there should be no performance goals with price analysis. Some traders might embrace a strategy that dictates, for example, "I must make $400 dollars a day." Trend followers would counter with, "Sure, but what if the markets don’t move on a given day?"

One trend follower summarized the conundrum:

"I could not analyze 20 markets fundamentally and make money. One of the reasons [trend following] works is because you don’t try to outthink it. You are a trend follower, not a trend predictor."

To be continued…