Systematic Relative Strength

—-attributed to Dave Steckler, former president of AAPTA

Over the weekend I read Michael Lewis’s new book, The Big Short. This is not going to be a book review, although the book is a lot of fun. It is the story of a few offbeat money managers who identified subprime CDOs as a good shorting opportunity and went on to make a lot of money. Lots of people, of course, could tell housing was overheated, but didn’t get the timing right or couldn’t find the right vehicles to execute the short position properly. In fact, one of the success stories in the book identified the overheated subprime market in 2005, took his short position, and then suffered massive redemptions and threats of investor lawsuits as he waited for the position to pay off. For the few success stories, how many other investors trying to short the market got gored?

Trend following strategies don’t attempt to predict bubbles. Instead, they are happy to play along with the trend until it shows signs of reversing. It doesn’t require prediction and you don’t run the risk of blowing up waiting for your (hopefully) correct forecast to pay off.

Now some academics have tackled this question. Is it better to play the bubble or to short it? CXO Advisory helpfully has a nice summary of their results. They write:

In summary, evidence indicates that riding industry asset bubbles (guided only by information on returns and fundamentals from the past ten years) may be an attractive investing strategy. Evidence does not support shorting bubbles.

In short, the trend is still your friend. While you sound much more intelligent discussing all of the reasons behind the bubble and what will happen when it pops, you will make more money going with the trend.

This entry was posted on Monday, May 24th, 2010 at 12:11 pm and is filed under Markets, Thought Process. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.