New testimonial

This week I received the following testimonial from Stephen, who I have now known for a number of years and has been an active member within our small group of traders:

Bill Ackman and Valeant Pharmaceuticals

The big news this week was the bloody nose that Bill Ackman and his Pershing Square fund received regarding their investment in Valeant Pharmaceuticals.

Following a dire update, the stock plunged to levels not seen since 2011, and has dropped almost 90% (yes, you read that correctly) from its all-time highs above $260 back in August.

Time for a rant

It's been a while since I had a rant, but I'm always astonished when I come across some articles like I've read over the last few days relating to the market drop since the turn of the year.

You get the usual comments from people who have lost money - ban short selling, ban hedge funds, the brokers are working in cahoots with the hedge funds, the market's rigged etc...

Combining technicals and fundamentals for investing

Recently I had the opportunity to review an investor’s portfolio. This was valued in excess of £1m. The allocation of the funds was entrusted to a well known brokerage. I was asked for my opinion on the performance and allocation of the fund.

Marty Schwartz and the sunspot theory

Every so often you come across a post from a trader talking about a specific stock along the lines of "Is there a reason NOT to own XYZ plc?"

Whenever I see a question like that, it immediately sets off alarm bells, which more often than not are confirmed when you go and look at a price chart of the stock in question.

Good letter writers write letters

"Market letters tend to lag behind the market since they generally respond to demand for news about recent activity. Although there are certainly important exceptions, letter writing is often a beginning job in the industry, and as such may be handled by inexperienced traders or non-traders. Good traders trade. Good letter writers write letters."

So said Ed Seykota famously in his Market Wizards interview.

Once in a while, I get chance to read some analyst or broker reports, be it relating to specific stocks, commodities or sectors, or general market conditions. How useful are these to a trader? How much reliance can you put on them?

A couple of recent trades

Below are the charts for the two most recent trades that have been closed, both for a profit. I have highlighted the relevant entry and exit points.

First to go was Nordic American Tankers, and we can see price fell quite a way below my exit point before recovering back in recent days to around the level where I was stopped out. Once a trade is exited, subsequent price action is of no concern to me - I move onto other opportunities.

Why I don't rely on fundamentals

There are undoubtedly a lot of traders, as well as the investing community, who place great faith in researching, analysing and interpreting the underlying fundamentals of a company. This information is then used to assist them make buying and selling decisions. However, some traders (like myself) place no reliance whatsoever on what the fundamentals are telling me.

Frankly, I don't care how many widgets they are making, whether the directors are buying or selling, or what the price to earnings ratio is. I'm far more interested in what price is doing, because ultimately the company's stock price and its movements is what generates a profit or a loss for a trader.

Price is the sole factor for a trend follower

People who read this blog will know that I focus solely on price rather than fundamentals. However I also know that people are successful focusing on fundamentals.

Lexicon Pharmaceuticals

Here we have another lovely profitable trend, this time to the upside. I guess from the name they are a pharmaceutical company but other than that I know nothing about them. The price action on the chart tells me everything I need to know, and want to know.

Richard Dennis, the legendary trader stated in his Market Wizards interview that "I could trade (an instrument) without knowing the name of the market". As far-fatched as that seems to those who spend hours pouring over earnings reports and calculating various ratios, that's exactly what I do when trading stocks.

Timing your beliefs or opinions

I've talked before about those people who use fundamental analysis, or economic indicators as a basis for their trading or investing decisions. Marrying those 'beliefs' or your own opinions with a trend following method can bring you superb results. I don't profess to follow fundamentals as part of my own trading decisions, other than vaguely keeping abreast of whats going on. The charts below (a collection of Spanish bank stocks) show that timing your beliefs (i.e. that the Spanish economy was struggling and may need a bailout) to coincide with what price is telling you can pay dividends. Doing this in 2007 and 2008 with the major UK and US financial instiutions made a lot of people a lot of money.

A brilliant quote

 "If you really know what's going on, you don't even have to know what's going on to know what's going on...You can ignore the headlines, because you anticipated them months ago".

Think about that, from the viewpoint of a trend follower, and/or someone who believes price precedes news. Then think back to the dot-com bubble, the 2008 market crash, or the recovery in 2009-10.

Incidentally, the quote above I got from Sebastian Mallaby's book More Money Than God, which plots the story of hedge funds since A.W. Jones's first 'hedge-d' fund in the 1960's, the birth of the concept and the original rationale of how such a fund would operate. Those of you who have read Market Wizards will immediately recognise some of the names in the book (along with other famous traders and hedge funds), including how the famed Commodities Corporation morphed from trading on ecomonic data to a trend following methodology. I came across the book yesterday in the local store, and have not been able to put it down since. An excellent read.

What's in a name?

A competent trend follower would be happy to place a trade regardless of what instrument or stock satisifes their criteria. Indeed, I can place trades on stocks without even necessarily noting the name of the company, other than for record keeping purposes. Often I do not even know what type of business they are involved in. If the set up fits, then I simply place the trade. In this manner, I avoid getting emotionally attached to any particular stock - it is simply a vehicle from which I cam potentially make money. It also saves hours poring over fundamental reports, studies of price to earnings ratios etc.

Although fundamentals can be a contributory factor, they do not solely generate profits for traders - movements in their share price do. If you doubt this, remember the dot com boom - if you ignored the dramatic increases in share prices (which in a lot of cases the companies concerned had absolutely no earnings or profits to report), then you would have missed out on those tremendous gains achieved in a relatively short period of time. And with a good trend following system, adhering to your exit signals would have ensured that you have banked the majority of those gains, only closing your positions when those huge run ups had exhausted themselves.

A good trend following system means you can trade stocks, indices, commodities and forex without basically changing any of the system rules. There is no over-optimisation of the parameters required for individual types of markets. If you are presented with a chart that satisfies your criteria, you would not even have to know what it is you are trading. It is because of this that trend following is the hardiest method to generate profits from your trading activities.

Two unarguable facts

I don't care what anyone says about the market, the following statements cannot be argued against:

• A company may have faultless fundamentals (based on information in the public domain), but if you are holding a long position in a downtrend, you will be losing money;
• A company may have lousy fundamentals (based on information in the public domain), but if you are holding a short position in an uptrend, you will be losing money.

This is why I believe investors and longer term traders should always have regard to the current price action, and the direction in which price is travelling. By all means use fundamental data in your selection of stocks to trade and/or invest in, but by also watching the price action and the resolution of old trends, or the formation of new ones, you can 'time' your entries and exits much better. This also means your capital will be tied up for less time in a non-performing stock.

A longer term trend following system for traders and investors

New for 2012 is a longer term trend following system, which I shall be trading to compliment my existing system. This aims to eradicate some of the whipsawing around when there are short term oscillations on the general market. The system will assist those who prefer to trade longer-term, as well as investors who use the more traditional investment type strategies.

The main benefit to investors, who tend to focus more on fundametal analysis, will be that the timing of the entry signals will coincide with a new trend forming based on the price action, as well as ensuring they get an appropriate exit signal when the trend has ended.

The system structure is the same as the original system, but the parameters used and timeframe have been changed. I will be maintaining a model portfolio and will be calling my trades in real time within the members chatroom.

The system rules are detailed in the members area - to join, click here.

Fundamentals, Investing and Trend Following

The vast majority of investors and longer-term traders use some form of fundamental analysis when selecting stocks to invest in. This is all well and good, but what triggers a buy or sell in their investments?

The usual story is that, once they believe that a particular company has good prospects and the fundamentals look promising, they will start to buy, with the intention of holding their positions until such point that the fundamental story changes. The trick is to realise when there is a danger of overstaying their welcome, and to exit their positions before losing the bulk of their profits. This is where a trend following system, geared towards longer term trading and investing, can be invaluable.

Although longer term investing can be profitable even when there are adverse general market conditions, it should be remembered that, in a sharp downtrend in the markets, even the strongest and best stocks fundamentally will suffer, as was seen in late 2008. Of course, when a downtrend like that starts, it is not known whether the affected stocks will rebound at least back to its former highs, or will even continue further downwards.

In the past, I have suffered abuse from the 'fundamentalists' on a bulletin board when my own trading system signalled the end of an uptrend in a particular stock, and therefore I exited my position with a nice profit. However, those who solely used their fundamental analysis accused me of de-ramping the stock (as if I could influence the markets!!!) and rubbished my own analysis. The stock in question was just below 50p at the time, having peaked at 60p a couple of weeks prior.

The investors I left behind continued to champion this particular stock, and some of the posters on the bulletin board in question 'loaded up' their position to almost absurd levels, so confident were they that soon they would be holding significant profits.

As of last week, that particular stock was at the 15p level, with a lot of investors now holding massive losses after 'buying on a pullback' which was actually a new trend - downwards. Some of those still holding shares are even blaming the directors for the lack of  recent positive news flow from the company for their losses!

Now, this may be an extreme example, but you only have to think about stocks such as Enron to know that people who were once sitting on huge profits in some of their investments managed to ride the share price all the way down, losing all of their hard earned profits. Enron fell from around $100 to 50c, with the true fundamental picture becoming apparent late in the day. You can also think of those who made (and lost) fortunes in the dot com bubble when prices collapsed there too. In these cases, it was not only individual investors, but hedge fund managers who also commited the same crime of not exiting their positions when the trend reversed - greed took over and they decided to load up even more.

Those of you who have read about Nicolas Darvas will know that he used a basic system marrying fundamental and technical analysis back in the early 1960's and did very well.

No system is perfect, and my intention is not to poke fun at those who have lost money by holding on too long - far from it. Everyone invests or trades to make money, however there is always someone on the other side of a winning trade, who loses money. Sometimes it is me, sometimes it is those who follow the company 'story'. Either way, if you are able to combine the two in your longer term holdings, I would be amazed if your overall returns did not improve.

Don't be blinkered by individual equity fundamentals

Trend followers should be trading solely on the basis of price action, however it is very difficult to ignore what is going on in the world and the increasing amount of economic doom and gloom. Those who like to incorporate fundamental or economic factors into their trading will have been looking solely at the short side for a while now.

The movements in the markets in August showed a sharp break down followed by a snap back rally of sorts, with some markets weaker than other - the German DAX for example, has not rallied as strongly as either the S&P or the FTSE.

I only use the indicies as a guide to assist whether I should be looking at the long or short side on individual equities, as the majority of stocks will tend to trend in the same direction as the indices. Even those stocks with the strongest fundamentals will be dragged down if the markets falls - Autumn 2008 and even last month showed that. Also remember that, in strongly trending markets, oversold and overbought indicators are rendered useless. The safest course of action is either to trade in line with the trend, or to be on the sidelines.

No doubt, if markets start to fall again, there will be people wanting to pick a turning point, and try to time the bottom. The easiest way to do this is the wait for the downtrend to end. So you don't get the bottom, to the penny - so what? Either way, I think it's safe to say that increased volatility will be here for a while to come.

Using trend following to 'time' your fundamental beliefs

Pure trend following means that price action is the sole criteria when deciding whether to go long or short. The argument for this is that, in a lot of cases, price leads fundamentals, not the other way round - indeed, in some of the Market Wizards interviews, some great examples were given of these types of trades. This is the way I personally trade. I fully appreciate, however, that lots of traders prefer to trade when the technical analysis side of a trade ties in with the prevailing known fundamentals. This would apply not only to individual equities, but also to the general market indices, as well as commodities such as oil or gold.

Trend following can help those who like to trade on their fundamental analysis by telling them when the time is right to follow their fundamental beliefs. In a strongly trending market, blindly following your fundamental beliefs, if the trend is against you, can result in a significant loss of capital.

You may decide that there is a particular company for which you are extremely positive or negative about their future prospects - simnply charging in and either going long or short without regard to current price action can result in a large loss. Why is this? Well, consideration must given to the state of the general market, for a start.

Those who have read Nicolas Darvas' book How I made $2 Million in the Stock Market will know that he made his money after identifying suitable companies based on their future prospects, but he also waited until both the price action of that company's stock AS WELL as the general maket conditions were right using his 'Darvas box' method to time his entry and minimise his risk to catch the big price increases he desired. He also then managed to hold onto his gains as he exited when his technical analysis told him to do so.

Although Darvas devised his own method for determining entries, exits as well as pyramid points, he was basically following an upward trend in those stocks, at a time when the general market was also going up. This is also where a pure trend following strategy scores, in that it helps you time your entries, as well as your exits - remember, we are not trying to pick tops or bottoms in any market, but simply waiting for a potential trend to appear, to play only when the odds are in our favour, and then get out when that trend has run its course. If that coincides with your own fundamental beliefs on whether that particular equity or market is going to rise or fall, then you have a green light to go trading.

What are you looking for?

It always slightly amuses me that, when the price of a stock starts moving, the trading and investing herd are trying to found out exactly what the reasons are for the move. A great swarm of sleuths converge, trying to nail down the elusive piece of data. 99% of the time, they are looking at news releases, fundamental data or other related titbits of information. Their findings are frantically and endlessly discussed in internet forums and on websites, fair values hurriedly recalculated and so on.

I read a piece recently about a trend following UK based hedge fund which predominantly trades Forex - they have been consistently successful, generating profits for their investors for a number of years, however their investors are repeatedly calling up wanting to know the reasons WHY the markets have moved. In the end, for their monthly reports the fund has had to 'create' a fundamental story to give to investors to 'back up' why they've taken the trades!!!

I will give you my take on why prices move - people buying and selling, and the price at which they are prepared to buy and sell. That's it - no more, no less.

And of those people buying and selling, you have NO idea of any other person's rationale for those decisions, (of which there can be tens of thousands of traders and investors, dotted around the globe) - they could be based on fundamental or technical reasons, based on different timeframes and outlooks, directors buys and sells, or a multitude of other reasons that necessitate an opening or closing of a position.

As I've stated here on more than one occasion, I focus solely on the price of a stock, and open and close positions as determined by my trading rules and criteria. All of the other stuff I ignore.

There are no doubt some people reading this who scoff that anybody can make money in the markets simply by looking at price. Yet there are simply too many stories of successful trend followers, who have made millions by following the price, for it not to be a fluke, or a series of lucky trades.

This is a collary of anther maxim about trading - "Do you want to be right, or do you want to make money?". The herd fall into the first category. The real winners fall into the second category.

I'm fully aware that there is more than one way to skin a cat. However, I'm more than happy to be judged on my trading performance, which is there for all to see, as detailed on the trades log. The rules that I adhere to are pretty simple, and I think the performance proves that simplicity in trading can work. I think I'll leave the hours of pouring over fundamental and economic data to others.

The KISS method of trading

I'm an advocate of the KISS method (Keep it simple, stupid!). I do not want to spend hours pouring over economic reports, company balance sheets, or any other form of fundamental data. Similarly, I place no reliance on technical indicators, which are lagging indicators, such as stochastics, RSI and the rest. There is only one piece of information that I look at - price. I used to track volume, but I found that didn't improve my results. So it's price, and price only.