AMONG PROFESSIONAL INVESTORS
, trend followers are characterized as mindless lemmings, unimaginative chart jockeys who ignore economic fundamentals and blindly chase securities regardless of price. It's the astute investor, so they say, who ignores market trends and uncovers value in off-the-radar names nobody else wants.
So as you work to develop your own investment philosophy, you might be wondering if it's more profitable to be a trend follower or a trend fighter. Truth be told, both are correct.
Realistically, successful investors eventually understand that in the end you have to follow (or anticipate) trends or you'll go broke. One doesn't last long constantly standing against the prevailing winds. The market is too large and too strong: You'll just get blown over.
Plus, why would you? As we've said over the years, it's our belief that the markets are not chaotic, but move in trends that persist for periods of time. The Nasdaq didn't fall from 5000 to 1500 in a day. To ignore this reality is to willingly suspend your awareness of the issue itself.
What does it mean that trends persist? Weather offers the most obvious example. I can't tell you what the exact temperature in Chicago will be tomorrow, but I'd take odds that it's not going to be 85 degrees and sunny. The basis for that bet is the fact I've observed, for the last two months or so, a trend toward dark, cold and rather gloomy days. It's not impossible that the temperature will hit 85 tomorrow in Chicago, but it is improbable. Dealing in probabilities is how profitable investors are able to consistently win over time.
Of course, to know what "season" the markets happen to be in involves doing research, which, in today's world, has come to mean briefly glancing at what other people think and taking their word on it. That's the lazy approach.
The best research, and thus, the best decision, is always the one you make from your own informed perspective. So you might talk to suppliers, pore over SEC filings, stay up late with annual reports and field test new products. That's slightly more effective, yet still one step removed from the one piece of information that matters most to your bottom line: price action. If you're going to profitably trade stocks, you should start by observing them. Nothing is more informative than the price of the actual security in which you're considering taking a position.
So I look at a ton of charts. Most laymen could tell you the Dow has been hitting new all-time highs, but few know how well Israeli stocks have been doing. How about Big Pharma, floating-rate funds or the business-development companies like Ares Capital Corp. or MCG Capital Corporation? You don't have to follow every trend, but you should be aware of the market's prominent themes at any given moment in time.
Even more important is the realization that being a trend follower doesn't necessarily make you a crowd follower. When a security rises substantially, it's a common fallacy to believe the sole reason is because everybody is piling in. While most commentators are quick to interpret a market trend as the result of some action of investors, as we pointed out a few years back, it's often their inaction that's ultimately responsible for the move.
The law of supply and demand is also that of demand and supply, and it's not the presence of buying, but the absence of selling, that can easily prompt a market higher. When there's not much stock offered, even a small increase in demand can send a price soaring. It's exactly why you can buy just a few hundred shares of low-float stocks like Cimatron Ltd. or bulletin-board obscurities like Mills Music Trust and quickly send their prices spiraling upward. Of course, when you go to sell, the same law applies prices collapse on a market order of 200 shares or fewer.
The mistake is to falsely assume that just because XYZ has risen 30% in the last few months, the herd has already piled in and all the easy money has been made. The reality is likely that a few steady buyers are meeting comparatively few sellers. Volume and message-board buzz are much better indicators of the crowd presence. On a large scale, the best example was the 1990s tech boom. According to mutual-fund data from the Investment Company Institute, most people finally got into the market in February of 2000, long after the real move (read: trend) had been in place for years.
Trend following isn't a profit panacea, but it is a state of mind that I strongly believe traders should embrace. The fact is that the world, markets included, moves in trends. Fighting them is a losing battle the limitless resources of the market will triumph over our few meaningless positions every time. We need not buy into every trend, but being aware of them provides the most meaningful insight into the markets there is.
Moreover, being a trend follower doesn't always mean you're part of the herd. Bull markets are built on doubt, and very often strong price action is the result of lack of supply rather that the presence of demand. The skilled investor might not always follow the market's trends, but he should never fail to respect them. In an environment where uncertainty is the norm, they are the closest one can come to knowing anything at all.
Jonathan Hoenig is managing member atCapitalistpig
Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.