What's Your Prior?

Momentum and Bubbles

November 11, 2020 Damian Handzy Season 1 Episode 4
What's Your Prior?
Momentum and Bubbles
Chapters
What's Your Prior?
Momentum and Bubbles
Nov 11, 2020 Season 1 Episode 4
Damian Handzy

Momentum traders make money violating the first principle of investing: previous performance is not indicative of future returns. As it turns out, what did well yesterday and the day before actually IS more likely to do well today. And Momentum traders, also known as Trend Followers, take advantage of that fact. But such trading, en masse, can lead to price bubbles. Join me and renowned Trend Follower Dr. Kathryn Kaminski as we explore how Momentum traders think about markets and when this strategy works the best.

Mentioned in this episode:

Show Notes Transcript

Momentum traders make money violating the first principle of investing: previous performance is not indicative of future returns. As it turns out, what did well yesterday and the day before actually IS more likely to do well today. And Momentum traders, also known as Trend Followers, take advantage of that fact. But such trading, en masse, can lead to price bubbles. Join me and renowned Trend Follower Dr. Kathryn Kaminski as we explore how Momentum traders think about markets and when this strategy works the best.

Mentioned in this episode:

Damian:

The Dutch are known for their financial prowess and for knowing the value of a dollar or Euro, or once upon a time a Floren . But it wasn't always that way. Back in 1634 tulips were a novelty in Holland. They were recently imported and still considered an exotic flower. And after Dutch botanists figured out how to breed tulips into more and more intricate patterns, their prices began to soar. Actually prices skyrocketed as more and more middle-class merchants wanted to make a quick floren. Many of these bulbs traded for, in today's money, between $50,000 and $150,000. And the best bulbs could fetch as much as $750,000. Now it seemed prices could only go one way: straight up. When a flower is worth as much as a comfortable house, it's pretty obvious that the market has entered a bubble. At least in retrospect, it's obvious. By 1636, there were so many places selling tulips that some of them were even listed on the stock exchanges in Amsterdam, Rotterdam, and Harlem. People started buying tulips on margin. They borrowed money to invest in what they thought was a sure-fire get rich quick scheme. What could go wrong?

Introduction:

Hello and welcome to what's your prior the podcast for the adaptable investor with your host, Damian Handzy.

Damian:

Welcome to this fourth episode of what's your prior . Now this episode is all about investing in securities that keep going up a strategy now called momentum by equity investors, and it's called trend following by commodity and future traders. As you can probably guess the Dutch tulip craze did not end well. By the end of 1637, tulip prices had crashed forcing many of the people who speculated in those flowers to declare bankruptcy. Now, while there's reason to believe that the story has been exaggerated over the centuries to serve as a warning to every investor who thinks he or she has found the secret formula for financial success, the story does make its point: bubbles can hurt you. That same phenomenon of prices rising consistently is used today by some of the most sophisticated investors to extract real excess returns. The idea is simple in principle: find securities that have established an upward trend in price and buy them. Hold on until they've ended their run. As soon as their prices start falling, you should get out. Now identifying when a trend is real can be quite tricky, but if you're good at it, it can be very financially rewarding. But just as important as it is to know when to get in, it's critical to identify when they get out. Many of our clients at Style Analytics use our factor analysis to understand how much exposure their portfolios have to high momentum stocks or for factor return attribution into things like growth, value, and, you guessed it, momentum. And we recently published a paper about how crowded many of these factor styles have become recently, and that the well-known tech stocks like Apple, Facebook, Amazon, and Google. Well, they're all simultaneously in the growth style and because their prices have taken off like a Tesla rocket, they're also all in the momentum style. So today we're going to explore this strategy with Katy Kaminski, who has literally co-written the book on the topic called Trend Following with Managed Futures. Katy has a PhD from MIT in operations research under the renowned behavioral economics professor Andrew Lo, and she is currently the chief research strategist and co-portfolio manager at hedge fund Alpha Simplex. Katy and I met in January of 2015 when we ended up being on a panel together, along with her coauthor at a hedge fund conference shortly after their book had been published. I started today's conversation with Katy by mentioning a paper that shows that the single best performing investment strategy across asset classes and across the decades is momentum or trend following. The message is that if you know nothing else about investments, just follow the winners and avoid the losers. It's almost as if the momentum strategy is mocking every legal disclaimer at the bottom of all those financial marketing materials we all see that warns us that previous returns are not indicative of future returns. N ow momentum says, Oh yes, they are. Now one person described momentum to me as a lemming strategy, just follow the winners. You don't have to think about whether companies are overpriced or you don't have to assess if they're a bargain or if they're in the right industry. Now, Katy, isn't that exactly the wrong way to think about markets?

Katy Kaminski:

That's a great question because I I've been a big fan of trend falling most of my career and trend falling to me is following where the market's going and using different methodologies and techniques to measure where markets are moving. What's fun about being a trend follower is that the main goal of what we do is to determine where markets are going, not to determine why they're going somewhere or particularly to forecast in such a way that we know what to expect from markets more than sort of what the crowd and what general mass groups of investors think the world is moving towards.

Damian:

So understanding what's causing the trends is not part of the analysis, is that right?

Katy Kaminski:

Exactly. And I think that's where people historically had a lot of challenge with the strategy. And what's interesting about that is that we're looking at where the markets move, as opposed, trying to determine why they're moving there. And why that's interesting to me is oftentimes you can know why something is happening, but it's very hard to know when. And so for our purposes, we're really not trying to ask the question we're trying to measure what's happening. And I think that's why institutional investors originally, or many investors out there were skeptical of the strategy because they thought it's much better to have a view about the economy. It's much better to measure all these different markers for fundamental value, but my argument might be that at what point did these fundamental values actually incorporate themselves into the market? There's many days where we have an announcement and the market has already incorporated it long, long ago. So I think that's the challenge is it's a great narrative, but the timing is actually quite challenging.

Damian:

So I offered Katy an analogy of trend following as driving down a dark winding road without a GPS, or without having looked at a map before you got behind the wheel. You just turn as the road turns, following it first left, then right, without knowing where you're headed or why you just react to the information that you have at that exact moment. If the white line on the side of the road turns left, you do the same. If it turns right. So do you.

Katy Kaminski:

I like your analogy a lot, in fact, because when I think about it from the perspective of markets, nobody really knows where they're actually going. And it's very, very hard to actually with certainty, predict the future when it comes to asset prices and how markets are going to evolve over time. In fact, they're very complicated and they're rapidly changing. And I think that's why these strategies in general make such a nice complement to a more fundamental approach, because let's be honest, we'd like to know where we're going, but we also need to be able to react to the world as it changes and be willing to not be too stuck on our own assumptions.

Damian:

So as a trend follower, do you ever ask whether are we in a bubble, are these assets overvalued ? If the trend keeps going up, will you keep contributing to the bubble, if we're in a bubble?

Katy Kaminski:

I mean, a hundred percent. I always feel oftentimes somewhat conflicted about how market positioning occurs and how markets move and whether or not I'm comfortable with those decisions. And that's sort of the natural part of being a systematic trend follower is that the system makes the decisions, not my emotions and I've often found, and this is something that's been very interesting being a trend fall over such a long time is that it's often in the moments where I'm the most uncomfortable, where my emotional reaction is the strongest where I disliked the uncertainty in the market times like elections times like crisis, where the trends can be the most successful. And I think that experience over time has taught me to be okay with feeling differently than how the trends are moving over time.

Damian:

How do you know when the trend is over? How do you know a new trend is beginning? How do you know when, when you should switch? How hard is it ?

Katy Kaminski:

That is the hardest part of trend-following. It's a balancing act. In some sense, we're always measuring across different frequencies, across different methodologies, using different techniques, using a whole basket of different methodologies to try and weigh out is this trend continuing, or is this trend ending? And over time, that means that we ease in and out of position slowly as we get more and more confirmation that things have changed. So a typical macro manager, someone who focuses on fundamentals can be right, but never see the trend occur for a very long time. Our challenges are we have to start see the trend occurring before we can actually get into it. And when we see it disappearing, we're also have to slowly see that confirmation as well. So it's not sort of a perfect timing strategy. It's more about balancing different methods, balancing different methodologies, and trying to estimate where we are in a cycle for a trend.

Damian:

We discussed the philosophically different approach that trend following takes from fundamental managers like value or growth investors. Those strategies involve a belief about how markets work. For example, value investors believe that certain stocks will rise in value because they have fundamental financials that will be rewarded in the market. And they can wait a long time for the market to reward them , uh , as they have for the past several years. Momentum traders, on the other hand, they don't hold beliefs about the market or well they do, but they don't trade based on those beliefs. They don't ask why something is priced either high or low. They just ask, well, what has worked? What has gone up? Even if it's already very high, if it goes up, it keeps going up. That's a trend. Now they follow that trend without regard to understanding what's making it. That seems like a very hard thing to do. Simply following the path without asking why that's counter-intuitive , but this approach clearly has advantages and it fits in with the Bayesian approach. Let reality be the basis of your beliefs rather than foolishly trying to get reality to bend to your preexisting beliefs. So I posed this to Katie, right? The fact that the fed has projected at interest rates are likely to remain low for the next several years that says that growth should continue to be favored over value. Does that knowledge, that scenario about the fed keeping rates low, does that get incorporated into trend following in any way? And the answer was clearly, no.

Katy Kaminski:

This is a perfect example. People have been looking for value to return because they believe that it's going to return for a long time. And that means that you could actually be wrong about what your views are for a very long time. From a trend following perspective, we're looking at momentum. So we're not going to be, we're going to be looking to measure where that particular theme has gone. So we would tend to not be in value and be more in growth over periods of time like this.

Damian:

When doesn't trend following work?

Katy Kaminski:

Trend falling doesn't work when things are very efficient, when things moving smoothly and there's no disruption and things are kind of humming along easily. And there's a lot of sort of noise around efficient value . So when finance fundamentals seem to work.

Damian:

All right , so Katy, what's the most interesting thing you've experienced as a trend follower?

Katy Kaminski:

My most interesting moments and trend-following has always been those pivotal moments like the Brexit vote or the U S election or times when things were very uncertain and very tense. Those are the moments - what I learned was that oftentimes the markets themselves were actually relatively reasonable at seeing where things were moving. I just didn't like those directions.

Damian:

Our conversation turned to how trend following is a naturally skeptical strategy and how it fits well with the Bayesian approach of not allowing prior assumptions or prior beliefs to get in the way of investing. As long as it's done systematically, Katie told me you can avoid painful instincts, like holding onto losing positions for too long, and you can avoid mistakes, like getting out of profitable positions too soon before they actually peak. Both of these are really hard to do if you don't follow a set of rules. So trend following fits well with a data-driven mindset and with Bayes' approach to decision-making. Now, if you're new to the podcast, I suggest you listen to episode one, to learn more about Bayesian thinking.

Katy Kaminski:

So I think that to me has been very interesting to watch is that even though I might have an opinion, or a prior, personally, about what I think is going to happen, on average, I h ave found that the market during uncertain times has a trajectory towards finding the right value. So from my perspective, that's when you need the disjoint decision-making between your system, making the decision and yourself and following the trend makes the most sense in the heat of the moment.

Damian:

All right, last question for you. What would it take for you to decide that this is wrong? This is not the right approach.

Katy Kaminski:

That's a good question. I mean, honestly, I don't think that there's any silver bullet. I do think that they, you know, over prolonged periods of time, if the strategy never worked and there was never any trends and human beings didn't herd and they didn't have aggregated behavior, then I don't think trend-following would work. The challenge is that I think human beings are markets are made up of people and that from time to time, we aren't that rational. So there will always be opportunities out there as things change as the world evolves and as we deal with disruption. So I don't think it's an easy strategy to trade, but I do think it would be hard to break it.