What's in a number?

What number can you believe in? The balance sheet? Earnings reports? Analyst forecasts? Consider this wise view on the only number we can all truly believe in:

"Michael: What do fundamental analysts analyze? It doesn't make sense to base an analysis on data containing errors. Example? H&R Block's error in allowance for income taxes was funny, but seriously, think about all the 'restatements' that I'm sure you've seen, some restating several years at a time. It doesn't make sense to base an analysis on numbers which are estimates. Numbers that are 'reserves' are estimates, by definition. Example? Banks can set earnings in quite a wide range by changing this period's addition to 'reserves for loan losses'. Yes, I've spent a lot of years working inside banks. You wouldn't believe what gets done to this poor number when the trial balance bottom line doesn't look good. The IRS won't let banks use this number; the IRS requires actual loan losses, instead. It doesn't make sense to base an analysis on numbers which are made up. Example? Worldcom, Enron, enough said. It doesn't make sense to base an analysis on numbers which have a high margin of error. Example? Most government statistics. Think about all the 'revisions' that I'm sure you've seen in the financial press. I have a friend who used to work with this kind of information inside the Federal Reserve. Some of his work went to Chairman Greenspan, who may understand error ranges, but how many other people who read these things in press releases really understand the confidence level? How useful would it be for a friend to give you a phone number for a dream date without telling you that he's only confident that the area code is correct. How do fundamental analysts know which numbers are wrong, are estimates, have large error margins, or are completely bogus? What is fundamental analysis worth if these numbers aren't screened out? If they are screened out, what's left?"
Chuck Cain

What's left that we can believe in as true? The market price.

No Money Management?

I received feedback from a reader looking to sell his trend following system. He described it:

"(My system) is a trend following system. It promises a systematic methodology for assessing trend or relative strength of an individual trading vehicle. As with all band or channel systems, when the prices do not show trend, they will remain within the band. When prices break though the band, it can be taken as a signal to either buy or sell."

Perhaps there is more, but where is the bet size discussion? Isn't that the most critical aspect? Where is the money management?

You Need the Process Down First

Discipline is the core of great trading. It is where the rubber meets the road. This question recently received from a reader of mine is instructive for all of us:

"Michael, I'm writing to you for advice. I got myself in a jam and don't know what to do. I recently got long an equity called Rambus. I built five units over a price from 36 to 38.5. The stock ran up to the mid to upper 40's and within a few weeks I was up around $6k. The company issued earnings last Wednesday after the market closed. The earnings were ok, nothing bad, nothing spectacular. The stock traded off a point or two, no big deal, normal volatility. However, the company is awaiting a verdict on a patent infringement case. Thursday afternoon, rumors were being spread that the verdict was released and it was negative for Rambus. The stock sold off roughly 15 points to hit a low of $29, but closed the day in the high 30s (around 38.5). While all of this was happening, I'm on the golf course playing golf with my dad and two brother-in laws. I had one contract at Ameritrade that got sold for a nominal loss, because I had a trade trigger in place. However the other nine contracts housed at my Fidelity account did not have trade triggers so I still have them. I basically lost $5,400 in one day (all gains) and still have nine contracts with a small profit of $500. Hence the subject title ... easy come easy go. Since this event, the stock has been trading above my exit signal. My question. Technically I should be out of those nine positions, but because I didn't have the trade triggers in I'm still long. Can I ignore the event because the price is back above my exit price? What would a trend follower do? A verdict is due out soon on this case. Many think the verdict will be positive for the company, however, if it is not, the market has given a clear indication that Rambus will be thrown under the bus. I sense you like to avoid answering questions like this, but I thought this was an interesting situation and maybe you can use it for educational purposes. Obviously I would not hold you to any guidance you provide. Best regards, Vinnie"

Some quick thoughts:

1. You are asking me for fundamental opinions to some degree. I don't have them.
2. You need to focus on a portfolio perspective so one market or stock is not the be all and end all.
3. Follow the price. That's all you can do.
4. Lastly, you need to have precise rules to follow the price. If the rules are not followed, for whatever reason, no one can offer you after the fact "proper" advice.

Monkeys Get Lucky

Trader Nassim Nicholas Taleb once wrote:

"If one puts an infinite number of monkeys in front of (strongly built) typewriters and lets them clap away, there is a certainty that one of them (will) come out with an exact version of the Iliad."

I have seen others take that thought and apply it to trend following creatively:

"...(all trend following performance from all trend followers) means nothing primarily due to survivorship bias and the effects of randomness. If you can show me statistical evidence of trend following working in any time frame, my hats off to you."

I don't get that comment. All trend following performance is just luck? And the lucky few survivors (apparently all of the trend followers in my book) are left over from an apparently long list of failed trend followers? That's the logic to explain away their performance results?

Another reader added to the discussion:

"The ultimate question is not about "survivorship," it's a question of suitability and adaptability. The track record of trend followers isn't just a record of survivorship - it's a record of adaptability under varying conditions. No one can get to their destination simply by theorizing about the nature of the destination - that's linear thinking. These folks do not get the journey (the process), so they focus on the surviving trend followers. They obviously have no clue how to get lucky. The key questions they ought to be asking are "how did these trend followers get to survive? ... how did they get to be 'lucky'?"

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Michael Covel Podcast

Michael W. Covel is the founder and President of Trend Following. A researcher of the most successful Trend Following investment managers, he has been in the alternative investments industry consulting on Trend Following to individual traders, hedge funds and banks for ten years. His best selling book, Trend Following: How Great Traders Make Millions in Up or Down Markets, New Expanded Edition (Prentice Hall, November 2005) is a complete and concise guide to trend following. It includes interviews with great trend followers who have won millions if not billions in the market. The trading world has embraced the book with endorsements from Van K. Tharp, John Mauldin, Ed Seykota and many more. Trend Following is now in its fifth printing, and is currently available in a Japanese translation with Chinese, German, French, Korean and Russian translations soon to follow. Teaching and sharing unique insights about Trend Following trading and alternative investments has earned Mr. Covel respect as a rational and logical voice in uncertain times. Mr. Covel also writes for numerous industry publications including Your Trading Edge, Stocks, Futures and Options Magazine and International Petroleum Finance and is consistently quoted and interviewed by a variety of financial publications.

Mr. Covel is also Managing Editor at TurtleTrader.com, the leading Trend Following news and commentary resource since 1996. Thousands of visitors from more than 70 countries as well as hundreds of trading professionals engaged in years of debate and interchange making the site the rich archive of trading information, data and opinion that it continues to be today. TurtleTrader, one of the largest & strongest trading community on the web with over 7.5 million unique visitors since its inception, also functions as a resource center for the Trend Following Educational Course.