“What do your models expect the market to do from here?” Some variation of this question is asked most every day. This type of question generally comes from someone who has not really internalized what a trend-following process is designed to do.
The following section from Michael Covel’s book, Trend Following, addresses this question by explaining the two broad categories of technical analysis:
There are essentially two forms of technical analysis. One form is based on an ability to “read” charts and use “indicators” to divine the market direction. These so-called technical traders use methods designed to attempt to predict a market direction… This is the view of technical analysis held by the majority–that it is some form of superstition, like astrology. Technical prediction is the only application of technical analysis that the majority of Wall Streeters are aware of as evidenced by equity research from Credit Suisse First Boston:
“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 predicts nor forecasts. This type is based on price. Trend followers form the group of technical traders that use this type of analysis. Instead of trying to predict a market direction, their strategy is to react to the market’s movements whenever they occur. Trend followers respond to what has happened rather than anticipating what will happen. They strive to keep their strategies based on statistically validated trading rules. This enables them to focus on the market and not get emotionally involved.
Since nobody knows exactly what the future holds, the better question for our strategy is what types of market environments are favorable and unfavorable for trend following. Trend-following strategies do well when there are longer-term trends in place. Environments in which stock market or asset class leadership is changing every couple months tends to be an environment in which trend-following strategies underperform. Investors shouldn’t get overly concerned about time periods when leadership seems to be in flux, given that it is impossible to look back in history and find even a decade where longer-term trends weren’t plentiful.
With the understanding that prediction has no place in a trend-following strategy, an investor is bettered prepared to focus on the process employed to adapt to longer-term trends. Focusing on a well-constructed investment process is much more productive than focusing on the unpredictable future.
—-This article was originally published on July 16,2009. We still fall into the technical adaptation camp. And we still see pundits making predictions every day, although their predictions are most often incorrect. Technical adaptation has performed very well since the time of this post. The more things change, the more they remain the same!
