God is a Capitalist

Thursday, March 3, 2016

Rescuing turtles - How the ABCT can help trend followers part II

Last week I introduced readers to trend following strategies of Michael Covel. Those who follow trends are sometimes called "turtles." Covel and others admit that trend followers have sailed into troubled waters lately.

The Austrian business-cycle theory can help trend followers by taking some of the uncertainty out of trend directions. During bull markets, such as characterized the first six years after the recession, the trend was up about 90% of the time with small dips because 1) the Fed was printing new money like a counterfeiter and inflation rose; 2) profits rebounded as the economy naturally turned around ,and 3) growing risk tolerance drove PE ratios to the sky.

Covel recommends trading the long term trends in his books and the expansion phase of the business cycle is one of the longest, lasting on average about six years. An trend following investor familiar with the ABCT will not mistake dips for trends.
Bear markets like the one we are launching this year tend to last about eighteen months and take in the recession phase of the business cycle when 1) profits are falling, 2) Fed money printing crashes into the concrete wall of diminishing marginal returns, and 3) investors pull their heads into their shells. ABCT trend followers will not “buy the dips” in recessions but remain sellers.

The ABCT suggests that trend followers hide during the transitions stages between expansion and recession when short term volatility spikes as bulls and bears fight over the direction of the market. Trend followers get hurt the most during transitions because no long term trends exist. Trend followers unfamiliar with business cycles will suspect that a trend is forming, but after they enter the market the trend reverses and causes regular losses.

Keep in mind that trend following traders snag the huge profits and losses because they use a lot of leverage. In other words, they trade futures and options contracts where the leverage is built in because the cost of the contracts is a small fraction of the total value of the contracts.

Another way the ABCT can help trend followers is in the knowledge it provides that capital goods industries have the largest up and down trends in the bull and bear markets. They are the high beta stocks, also known as cyclical stocks and can be found mostly in the NASDAQ. Consumer goods, and of course utilities, are secular stocks. They have betas lower than the market, generally trend upward but with very little slope to their climb and that means meager profits.

Commodities follow super-cycles that are much longer than the typical business cycle, often ten years from top to bottom or bottom to top. Super-cycles exist in real estate as well as commodities. Wise investors will pay attention to where they are in the cycle and not fight the long term trend by buying when the super-cycle in declining or selling when it is rising.

Limiting risk

Trend followers lean heavily on stop loss orders in order to limit their losses when the market moves against them. But SophisticatedInvesstor.com reports that the New York Stock Exchange will quit allowing stop loss orders this month and NASDAQ will follow.
According to a statement issued by the NYSE last week, “Many retail investors use stop orders as a potential method of protection but don’t fully understand the risk profile associated with the order type. We expect our elimination of stop orders will help raise awareness around the potential risks during volatile trading.” In other words, the NYSE feels that your average investor might enter a stop order to protect him- or herself but lose far more than expected when the market is moving quickly...
If investors can’t rely on stop loss orders to calculate risk, then the trend following trading system becomes even more vulnerable. But there are good reasons for investors to avoid stop loss orders according to MarketWatch:
Another problem with a stop loss order is that when you enter it into the computer, the order is transparent. A game that some market-makers played (these days, it will be computer algorithms) is “run the stops,” when they force the stock down or up enough to trigger a large cluster of stop loss orders (usually at round numbers or well-known support and resistance levels). After the stock is sold at a popular stop loss price, the algorithm stock reverses direction and the stock rallies or falls.
I still believe in stop losses, but not the automatic kind. Rather than using automatic stop losses, I set up price alerts for the securities I bought (and for those I plan to buy). For example, if I buy XYZ stock at $20 per share, I might set a price alert at $19 (5% loss), and also at $25 (25% gain).
Expectations are an important part of both the ABCT and trend following. As I have written before, the great Austrian economist Ludwig Lachmann emphasized the importance of expectations in determining market prices. He wrote that market participants don’t expect only a single prices for stocks, but instead have a range of prices in mind with floors and ceilings, or in the language of trend following, support and resistance. As the price approaches one of the upper or lower limits of the expected range, most investors expect it to reverse direction and eventually head for the other boundary. Most of the time market prices do just that.

Only when something extraordinary happens will the price break out of the expected range. A price jail break lets the investor know that his expectations must change, but changing expectations takes time. For example, the latest correction in the market didn’t last long enough for most investors to recalculate their expected trading range. Prices must remain outside the expected range for several periods before investors will reboot their ranges. But determining how long it takes is difficult.

Trend following tools help investors discover the market’s expected ranges between quarterly announcements of profits and how to react when break outs occur. Investors can boost their success rates by using the ABCT to understand which phase of the business cycle the economy travels in and when transitions are taking place. The ABCT helps clarify long term trends. 
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