Victor Niederhoffer on Trend Following

The Speculator Why the trend is not your friend

Many technical traders stake their futures on following the crowd. But every trend can turn on you, because what goes up usually comes back down -- and vice versa.

By Victor Niederhoffer and Laurel Kenner

Posted 5/2/02

The stock market has been a trend-followers dream for the last few weeks. On March 22, a close below 1,150 in the S&P 500 futures set all the bearish indicators in motion. Confirmations of a downward trend through regression lines, moving averages, pivots, Bollinger bands, you name it, were triggered. Over the next 24 trading days, the market closed 10 times at 20-day lows. Rule No. 1, carved in stone for all technical analysts, is that the trend is your friend. If ever there were a time that we could, along with the Cabot Market Letter, report the beauty of using a simple trend-following indicator that makes it virtually impossible to miss a major market move, this would surely be that time. No wonder that 830 aspiring chart-readers, the most ever, registered for the Market Technicians Associations annual competency exams on April 26 in Jupiter Beach, Fla. Granted that some users of trend following have achieved success. Doubtless their intelligence and insights are quite superior to our own. But its at times like this, when everything seems to be coming up roses for the trend followers theories and reputations, that its worthwhile to step back and consider some fundamental questions: Is their central rule, The trend is your friend, valid? Might their reported results, good or bad, be best explained as due to chance? But first, a warning: We do not believe in trend-following. We are not members of the Market Technicians Association, or the International Federation of Technical Analysts or the TurtleTrader Trend Followers Hall of Fame. In fact, we are on the enemies list of such organizations. These posts on the TurtleTrader site, which describes itself as the worlds No. 1 source for trend-following, referring to an April 2001 interview with Vic in Technical Analysis of Stocks and Commodities are typical: Niederhoffer says that trend following doesnt work, and is doomed to failure. Heres a guy who blew up his own trading account in a spectacular fashion, and hes knocking systematic trend following Niederhoffer, like so many, ignores the bottom line success of trend following. To accept any of what Niederhoffer says is to ignore the existence of Bill Dunn, Jerry Parker,

Richard Dennis, John W. Henry and all of the many Turtles. But trends always turn Lets turn to actual results on trend-following, using annual data provided by the authors of "Triumph of the Optimists: 101 Years of Global Investment Return", which we consider the best investment book ever written (See our April 11 column.). As we reported last week, trends in annual returns have been absent over the last 102 years. For consecutive years, the correlation is -0.02. The correlation between the return in one year and the return two years later is -0.25. In recent years, the correlations have been even more negative; three consecutive negative annual returns were last seen 70 years ago. As authors Elroy Dimson, Paul Marsh and Mike Staunton point out in "Triumph," there have been only six occasions in the last 102 years when the market declined for two years in a row. Thats not enough for reliable statistical conclusions. But the average return in the following year is 16% -- the highest possible third-year average of all possible directional combinations for a two-year period, tying with the down-up combination. Up/down combinations Year 1 + + Year 2 + + Year 3 gain 9% 16% 13% 16%

Perhaps short-term trends in the averages support the trend-following view? No, not there, either. Correlations between consecutive non-overlapping periods of various duration in the most widely traded stock futures are negative, showing what is called mean reversion. In other words, big declines in the averages tend to be followed by big rises and big rises tend to be followed by big declines. (Medium moves tend to be followed by medium moves.) A good ballpark estimate for those correlations, for the statistically minded, is -0.15. The situation for individual stocks also favors the anti-trend school. Jonathan Lewellen, an instructor at MIT, wrote a series of papers showing that for the 66-year period from 1932 to 1998, the average stock went back some 41% toward the mean over the next six quarters vis--vis its performance in a single year. From 1968 through 2000, Lewellen found the correlation was -24% -- somewhat less, but still significant. In other words, if the return on a stock is 50 percentage points below the mean in one year, the best prediction you can make for the next six quarters is that it will go up some 24% x 50%, i.e., roughly 12% above the mean. After going through millions and millions of careful calculations, and correcting for all

the usual biases in studies of this nature, Lewellen concludes: The evidence for mean reversion is strong. How is trend-following doing right now compared with mean-reversion investing? After all, academic findings too often come down the pike at exactly the wrong time for investors. In a classic example, a groundbreaking 1981 study showing that small stocks consistently outperformed large ones was followed by 18 years of small-cap underperformance. The bad stretch began in 1983, after a honeymoon period that gave the numerous new small-cap investment vehicles inspired by the study enough time to attract a lot of money. Dimson, Marsh and Staunton called attention to this reversal of fortune in a 1999 article titled Murphys Law and Market Anomalies. Ironically, the year the article was published, small caps went on to record one of their best years ever; and in 2000 and 2001, they outperformed the S&P 500. Normally, after showing that all the evidence is against a theory, we would be content to end with a snappy conclusion to the effect of the trend is not your friend. Yet no fixed rule can be expected to last forever. Too many smart people are around to anticipate and dissipate the effect. Thus, the cycles are always changing, as racetrack expert Robert Bacon first documented in his classic, Secrets of Professional Turf Betting. Will declines now follow declines? Given that the evidence over the last 60 or 70 years is antithetical to the trend-followers on individual stocks -- and that recent evidence on trends in the averages is equally unfavorable -- is there any evidence that things are about to change? After all, S&P 500 futures had three consecutive monthly declines in June, July and August 2001, resulting in a drastic 10% decline. Then, from the end of August to Sept. 21 -- well, the tale is too sad to tell. But the market panorama is rich enough to find anecdotes that seem to support any kind of market relation. To find out whether the cycle might be changing once again, who ya' gonna call? The Speculators. We took the 20 best and worst performers in the S&P 500 during the year 2000. (The current S&P 500 contains a few companies that were not around at the beginning of 2000, so it was necessary to eliminate all such new additions from our tally.) Looking at the performance of these stocks over the subsequent 16 months, through April 29, 2002, we found that the 20 best stocks of 2000 returned an average of -11%. Calpine (CPN, news, msgs), down 76%, PerkinElmer (PKI, news, msgs), down 76%, and Allergan (AGN, news, msgs), down 32%, were among the bests that stumbled. (The situation would have been even worse if such stocks as Enron, a stalwart member and top performer of the S&P in 2000, had been included. Enron was delisted in November 2001, so we had to drop its bad results, which would have taken an additional 5 percentage points from the 20 best.)

The 20 worst stocks of 2000 were unchanged in the next 16 months, on average. That list included stocks such as American Greetings (AM, news, msgs), up 91% from Dec. 29, 2000, through April 29, 2002; Apple (AAPL, news, msgs), up 55%; Cendant (CD, news, msgs), up 91%; Circuit City (CC, news, msgs), up 86%; and Dell (DELL, news, msgs), up 48%. The S&P 500 Index itself declined 19% in the 16-month period. In sum: Rankings and returns S&P 500 stocks 2000 rank 20 best 20 worst S&P 500 index % return next 16 Mos. -11 -0 -19

Of course, buying the worst is by no means the road to guaranteed riches. Yahoo! (YHOO, news, msgs), down 86% and the second-worst performer of all in 2000, went on to lose 53% more in the subsequent 16 months. Novell (NOVL, news, msgs), Lucent Technologies (LU, news, msgs), Gateway (GTW, news, msgs) and WorldCom (WCOM, news, msgs) saw similar continuity of losses. Putting one consideration with another, however, there is no recent evidence of a regime shift. The weight of academic findings and practical results indicates that the tendency to mean reversion is intact. We conclude that evidence for all periods, all individual stocks, all averages and all new indexes that we might reasonably think of is against the trendfollowers. Our market shrink, Dr. Brett Steenbarger, whose work is often featured on MSN Money, frames the issue this way: Technical analysis is like an X-ray; it generates pictures of market conditions. Accurate diagnosis, however, must determine exactly how far conditions deviate from the norm and perform tests that cannot be conducted by radiology. "For a trader to limit himself to technical analysis is like a physician limiting diagnosis and treatment to X-ray findings," he concludes. A picture may be worth a thousand words, but a positive finding on a blood test will never show up on the picture. Final note The beginning of a month is always a good time for a trend to change, and thats when we like to buy individual stocks. In view of the recent negative trends, this seems like a particularly salutary time to participate in the 1.5 million percent-a-century juggernaut. We are very bullish for this year and the next, and we have been purchasing shares of companies that announce buybacks and biotech stocks with a preponderance of recent insider buying. Our buys in both groups are based on statistical studies that we have reported on in detail here over the past few months.

Since our list of buybacks was published on April 18, three others -- Charter One Financial (CF, news, msgs), IBM (IBM, news, msgs) and Kimberly-Clark (KMB, news, msgs) have announced buybacks, and we will be buying them accordingly. Of the 20 worst performers in the S&P in the last 12 months, we note that eight of them have recent insider buying: Companies with insider buying Company Qwest WorldCom Vitesse EMC Dynegy Solectron Gateway Mirant Ticker Q WCOM VTSS EMC DYN SLR GTW MIR % decline 4/30/01-4/30/02 -88 -87 -83 -77 -76 -72 -70 -70

We like them as a group, and we accordingly will be buying them. Four -- Mirant, Solectron, EMC and Dynegy -- not only have insider buying but have announced buybacks. Thus, according to our statistical studies they are buys on three separate systems: buybacks, reversion to mean and insider purchases. Well be buying double quantities of these, with the exception of Dynegy, as it rose 30% on Tuesday. As we write on Wednesday, the Dow has rocketed above the magical 10,000 once again and the seesaw has tilted in our view to the shortterm neutral. Thus, we will wait to accumulate all the good issues mentioned on weakness rather than buying into this recent strength. We will be pleased to send you our workout of the 20 companies in the S&P 500 that were the worst in 2000, adjusted for survivorship bias. Please be free with your critiques and encomia, especially the latter, as we anticipate a deluge of vitriol from the trend-followers on this one. Write to gbuch@bloomberg.net.

At the time of publication, Victor Niederhoffer and Laurel Kenner owned or controlled shares in the following equities mentioned in this column: IBM.

Michael Covel (February 16, 2005)

Sometime back we outlined insight into Vic Niederhoffer. Today he offers at MSN Money a critique of trend following: http://moneycentral.msn.com/content/P22198.asp TurtleTrader comment: Sure trends turn. The point is? Do you think trend following doesn't account for such? Trend Followers don't follow crowds. They take advantage of crowds. And profit. The stock market has been a trend-follower's dream for the last few weeks. TurtleTrader comment: The last few weeks? Is that the time horizon one must have? On March 22, a close below 1,150 in the SP 500 futures set all the bearish indicators in motion. Confirmations of a downward trend through regression lines, moving averages, pivots, Bollinger bands, you name it, were triggered. Over the next 24 trading days, the market closed 10 times at 20-day lows. Rule No. 1, carved in stone for all technical analysts, is that the trend is your friend. If ever there were a time that we could, along with the Cabot Market Letter, report the beauty of using a simple trend-following indicator that makes it virtually impossible to miss a major market move, this would surely be that time. TurtleTrader comment: So now is different? This time is different? Why? No wonder that 830 aspiring chart-readers, the most ever, registered for the Market Technicians Association's annual competency exams on April 26 in Jupiter Beach, Fla.

Granted that some users of trend following have achieved success. Doubtless their intelligence and insights are quite superior to our own. But it's at times like this, TurtleTrader comment: What is unique about this time? Have markets now changed? when everything seems to be coming up roses for Trend Followers' theories and reputations, that it's worthwhile to step back and consider some fundamental questions: Is their central rule, The trend is your friend, valid? Might their reported results, good or bad, be best explained as due to chance? But first, a warning: We do not believe in trendfollowing. TurtleTrader comment: The existence of trend followers are optical illusions? 30 years of trend following results are chance? We are not members of the Market Technicians Association, or the International Federation of Technical Analysts or the TurtleTrader Trend Followers Hall of Fame. In fact, we are on the enemies list of such organizations. TurtleTrader comment: We are not your enemy. But your comments are off. These posts on the TurtleTrader site, which describes itself as the world's No. 1 source for trend-following, referring to an April 2001 interview with Vic in Technical Analysis of Stocks and Commodities are typical: Niederhoffer says that trend following doesn't work, and is doomed to failure, but he blew up his own trading account in a spectacular fashion. Niederhoffer, like so many, ignores the bottom line success of trend following. To accept what Niederhoffer says is to ignore the existence of all trend traders But trends always turn TurtleTrader comment: It's why Trend Followers make money. How could trend following win if it did not account for a trend turning? Normally, after showing that all the evidence is against a theory, we would be content to end with a snappy conclusion to the effect of the trend is not your friend. Yet no fixed rule can be expected to last forever. TurtleTrader comment: Trend following wins for it is flexible. It adapts to change. Given that the evidence over the last 60 or 70 years is antithetical to the trend-followers on individual stocks -- and that recent evidence on trends in the averages is equally unfavorable -- is there any evidence that things are about to change?

TurtleTrader comment: We must expect the market to change into something that no one has ever seen before? Looking at the performance of these stocks over the subsequent 16 months, through April 29, 2002, we found that the 20 best stocks of 2000 returned an average of -11%. Calpine(CPN, news, msgs), down 76%, PerkinElmer(PKI, news, msgs), down 76%, and Allergan(AGN, news, msgs), down 32%, were among the bests that stumbled. (The situation would have been even worse if such stocks as Enron, a stalwart member and top performer of the SP in 2000, had been included. Enron was delisted in November 2001, so we had to drop its bad results, which would have taken an additional 5 percentage points from the 20 best.) TurtleTrader comment: It sounds like Victor is a long only guy? Putting one consideration with another, however, there is no recent evidence of a regime shift. TurtleTrader comment: Regime shift? The weight of academic findings and practical results indicates that the tendency to mean reversion is intact. We conclude that evidence for all periods, all individual stocks, all averages and all new indexes that we might reasonably think of is against the trendfollowers. Our market shrink, Dr. Brett Steenbarger, whose work is often featured on MSN Money, frames the issue this way: Technical analysis is like an X-ray; it generates pictures of market conditions. Accurate diagnosis, however, must determine exactly how far conditions deviate from the norm and perform tests that cannot be conducted by radiology. For a trader to limit himself to technical analysis is like a physician limiting diagnosis and treatment to X-ray findings, he concludes. A picture may be worth a thousand words, but a positive finding on a blood test will never show up on the picture. TurtleTrader comment: How can you take the above paragraph and determine what to buy along with when and how much? And then when do you sell? The beginning of a month is always a good time for a trend to change, and that's when we like to buy individual stocks. TurtleTrader comment: If this the tip of the day, how much of what do we buy? Will you call when it's time to sell? In view of the recent negative trends, TurtleTrader comment: What is a negative trend?

this seems like a particularly salutary time to participate in the 1.5 million percent-acentury juggernaut. We are very bullish for this year and the next, and we have been purchasing shares of companies that announce buybacks and biotech stocks with a preponderance of recent insider buying. Our buys in both groups are based on statistical studies that we have reported on in detail here over the past few months. We will be pleased to send you our workout of the 20 companies in the SP 500 that were the worst in 2000, adjusted for survivorship bias. Please be free with your critiques and encomia, especially the latter, as we anticipate a deluge of vitriol from the trendfollowers on this one. TurtleTrader comment: No vitriol Vic. You just make no sense. We welcome feedback from readers.