The following article is adapted from Dr. Thomas Carr’s upcoming book, ” Market Neutral Trading” (McGraw-Hill), due out in 2014. 

stock-market-articleDr. Thomas K. Carr, aka “Dr. Stoxx”, is founder and CEO of Befriend the Trend Trading, one of the web’s longest running trading training programs (www.drstoxx.com).  His flagship advisory, The Trend Trade Letter, boasts an ROI of over 2,000% since its inception in 2002!  Dr. Carr is also the author of two bestselling books in personal finance: Trend Trading for a Living and Micro Trend Trading, both published by McGraw-Hill.  He has been actively trading the markets since 1996 following several years of studying technical analysis. He holds a doctorate from Oxford University and was a tenured Professor to liberal arts students for 16 years. He has been interviewed by Investor’s Business Daily, The Wall Street Journal and US News and World Report for his insights into the markets and has had a series of articles published in Stocks and Commodities Magazine.

Back in 2008 after the market crash, I began a multi-month search for a more sustainable set of trading systems.  I had always been a technical analyst, relying on my readings of price charts alone to get me safely in and out of the markets.  But in those crazy days of trading during and after the crash, technical analysis alone was not doing the job.  I knew of market experts who were able to get safely to the sidelines shortly after the top of 2007.  They were also the ones backing up the truck to load up on cheap shares after the March, 2009, bottom.  What did they have in common?  A thorough education in market fundamentals.  I, on the other hand, as a good technical analyst, was out there buying the 2007 dips and selling short the 2009 rallies.  Of course, none of that worked out very well!

What I learned from my study was that fundamental analysts generally fall into one of two camps: some believe that the market tends to “discount” or price in a company’s financial information correctly and efficiently as soon as it becomes available — what is called “efficient market theory” — while others believe that there are elements of inefficiency at work in the discounting process that can be exploited for gain.  This is obviously a crucial divide.  For if the stock market is truly efficient, then predicting future price movements on the basis of a company’s future earnings prospects becomes a pointless endeavor.  If all fundamental data is accurately assimilated into the present price of a company’s stock, then a company’s earning potential is already reflected in that price; thus there is no way to outperform the overall market on that basis.   On the other hand, if the markets are truly inefficient, where price does not always match the underlying fundamentals, then there is room to capture alpha (market gains beyond the returns of the S&P500), and maybe lots of it.

I also discovered a second major division, related to the first.  Some believe, as I always have, that there is a genuine edge to future market prediction.  The general assumption of these “market timers” is that price and earnings momentum, whether up or down, are more likely than not to continue their trends going forward.  In other words, if a stock is rising in price, it is more likely to continue rising than to fall; or if company X is showing a significant quarter on quarter earnings decline, it will likely continue to decline in the coming quarter.  On the other hand, there are theorists who argue that consistent market prediction is not possible using either technical or fundamental analysis; that changes in stock prices over time are purely random events.  These so-called “random walk theorists” claim that stock price distribution models show no consistent signs of predictability; that just because a stock went up last week, last month, and last year, the chance it will go up tomorrow is the same as calling a coin toss.

Here is the bottom line: both the efficient market theorists (EMT’s) and the random walk theorists (RWT’s) contend that the quest for alpha is no more possible for a highly paid analyst than for a monkey throwing darts at The Wall Street Journal.  EMT’s and RWT’s are very smart people.  Many are Ivy League professors of finance; some hold important posts in government and industry.  Who was I to take the other side of that argument?  To be sure, standing with me were legions of fund managers, Certified Market Technicians, independent traders, armchair investors, and other species of alpha hunters.  We all believe analysis — either technical or fundamental — can provide a market-beating edge. But on what grounds?  This was the question I desperately needed to answer.

For many decades, the EMT’s and RWT’s were a rather inconsequential subculture among financial professionals.  That changed in 1973 with the publication Burton Malkiel’s classic, A Random Walk Down Wall Street.   As an economics professor at Princeton, Malkiel had the academic chops to give the book real gravitas, but his folksy spin on the whole analyst’s game of chasing alpha made it accessible to the general public.   To date the book has sold over 2 million copies (unheard of for an economist!).  In A Random Walk Down Wall Street, Malkiel successfully harnessed both EMT and RWT to forward a coherent set of reasons why it is impossible to outperform the stock market.  I like to summarize Malkiel’s EMT-RWT synthesis as follows:

While current share price of any publically traded company can be rationally explained given what is known about the company’s financials, there is no reliable way to predict share price going forward; there are simply too many indeterminate variables that can cause stock prices to fluctuate in ways that were not expected.  In other words, the only information we have in a company’s current share price and valuation is past information.  And when it comes to stock market predictions, what is past is not always prologue.

Malkiel concludes, though a fair bit more eloquently, that both technical and fundamental analysis are a complete waste of time.[1]  Both technical analysts and fundamental analysts believe they are able from past information to project the most likely future movement of a stock’s offering price (up, down or sideways).  But the EM/RW theorist insists that there is no edge to that predictability without taking on increased risk which, in turn, wipes out the edge.  As Malkiel puts it, the probability of a company’s shares moving up or down is as calculable as the statistical distribution of a thousand coin tosses.[2]  Each new price point, he insists, is neither the product of price momentum continuing from the current trend (as per the technicians), nor an extension of earnings potential carrying over from previous earnings growth (as per the fundamentalists).  It is merely the efficient assimilation of a hundred different information vectors, some of which are unknowable ahead of time.

So where did this assessment leave me?  After all, I was making a pretty good living predicting the future price trends of the stock market.  Was it all just a fluke?   Eleven years of profitable performance on over 3000 trades, all published on our public website, Befriendthetrend.com: was that all simply a matter of good fortune?  What about the hundreds of traders I’ve trained over the years, some of whom are now trading professionally: did they just catch me on a lucky streak?

What about software systems that mechanically process reams of market data in order to find and execute profitable trades?  One such example is Trade Miner, a phenomenally profitable trading tool that isolates repeated seasonal patterns in stocks, futures and forex pairs.  Pair Trade Finder is another such tool.  It teases out of the market highly correlated stock pairs and alerts users to when statistically significant divergences occur in those pairs.  These and many similar “quant” based algorithms are being used every day by market professionals to exploit repeatable market trends.  How is this possible if the markets are nothing more than a “random walk”?

No, the more I read  Malkiel and the proponents of Efficient Market/Random Walk theory, the more I began to smell the stench of the very thing I was seeking to dispel from my trading life (and from my life as a whole): the fear of taking a risk.  This “spirit of fear”, as the Bible calls it, is what too often holds us back from taking the trade when we should, and causes us to make the trade when we shouldn’t.  EM and RW theories are ripe with the fear-based counsel that it is better to retreat to the safety of passively managed index funds than to risk the random elements that affect individual stocks.  I stand opposed to this counsel.  I believe that to orient oneself so as to avoid risk is to gravely miscalculate the human capacity to transform risk into opportunity.

Malkiel is right to point out that the risks involved in trading and investing cannot always be determined ahead of time and certainly need to be accounted for; but what he won’t tell you is that the risks associated with standing aside out of fear are far worse.  At the time of this writing, the call of the random walkers to stick to passively managed index funds has been wrong for thirteen years running.  $1,000 invested in the S&P500 from January 1st, 2000, to March 1st, 2013, would still be worth only about $1,000, and likely less once inflation is taken into account.  On the other hand, during those same years some amazing fortunes could have been made by risk-taking stock pickers using time-tested strategies.  Consider the following returns gleaned from the American Association of Individual Investors’ database of various strategies over the same the thirteen year period: [3]

Investment Strategy

Starting $

Ending $

Annual ROI

Total ROI

S&P Index Fund

$1,000.00

$970.00

-0.2%

-3.0%

John Templeton

$1,000.00

$3,500.00

10.1%

250.0%

Joel Greenblatt

$1,000.00

$3,600.00

10.2%

260.0%

Warren Buffett

$1,000.00

$3,650.00

10.5%

265.0%

Peter Lynch

$1,000.00

$4,000.00

11.2%

300.0%

Martin Zweig

$1,000.00

$9,900.00

19.3%

890.0%

O’Neil’s CAN-SLIM

$1,000.00

$16,600.00

24.7%

1660.0%

 

Figure 2: Passive vs. Active Investing – comparison of returns (1/1/00 to 1/1/13)

 

So, what is the take-away from all this?  Simply that you CAN beat the market.  You will need a profitable and sustainable set of trading systems.  You will need a robust approach to position management and risk control.  You may also need coaching from a mentor who can guide you safely through those first few years of the learning curve.  But trading is not rocket science.  I have trained thousands of traders, from all sorts of backgrounds.  I’ve trained finance professionals and housewives, investment bankers and cupcake bakers.  Many of my students are now trading for a living, or at least providing a healthy second income.  So I know you can prove the “random walkers” wrong!  You CAN buy the bottoms and sell the tops (or at least close to them).  You CAN execute a set trading strategies calmly, fearlessly, and flawlessly.  You CAN, with prayer, faith, and a lot of hard work and perseverance, steward well the gifts and resources granted you (however small they may be now).  God bless your trading, and God bless your willingness to take on the risks that come with investing in the future.  If I can be of any help in your trading journey, please don’t hesitate to write me at: drstoxx@drstoxx.com.

© 2013: Befriend the Trend Trading, LLC

 


[1] Cf. Burton Malkiel, A Random Walk Down Wall Street, 10th ed. (New York: W. W. Norton & Co., 2012), chapter 5.

[2] Ibid., p. 143.

[3] The figures used in this table are based on information taken from AAII.com, the website for the American Association of Individual Investors.  The 10-year average annual return from 2002-2012 listed on the site was applied to the thirteen year period to arrive at a total ROI to match that of the S&P500.  As with all financial information posted on websites, even one as professional and as well-respected as AAII, certain disclaimers apply.  Here is the pertinent part of the disclaimer found on the site: “The opinions and analyses included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty, expressed or implied, is made as to their accuracy, completeness, timeliness, or correctness. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or any delay or interruptions in the transmission thereof to the users. All investment information contained herein should be independently verified.”