Taking Another Shot At Market Efficiency

The market is inefficient.

What I mean by this is that the market is always in a state of controlled chaos. Some may consider this equilibria, but it is equilibria in a very limited sense of the word. Equilibria is not the same as intrinsic or fundamental value (which is also in the eye of the beholder).

Because market prices are a function of consensus feelings, emotions, expectations and sentiment regarding earnings, interest rates, risk and the future (in other words they reflect the current zeitgeist of the day and embed some feelings for the future), they are necessarily wrong all the time. No one knows what the future holds. Of course as markets correct and swing from overvalued to undervalued and vice versa, they must by definition pass through some median or fair value point. The problem is they rarely trade at the fair value point for any steady state period of time.

Getting cyclical trend and momentum right are consequently the most important ingredients to long term active investing, while have a mean reversion contrarian disposition can help cut off the excesses of the tails. The problem is we never really know beforehand the timing, time or magnitude of any new cycle.

Therein lies the problem.

Implications of Momentum Investing

Trend following, aka momentum investing is probably the weakest part of my investing DNA. I am a natural contrarian with a strong value tilt. I have learned the value of growth and the importance of sentiment and momentum, but they are still both hard for me to fully commit  to.

Over the past 10-15 years research has vindicated and validated trend following strategies as a way to add alpha. Consequently, and in conjunction with the increasingly quantitative/algo driven basis of the market, I believe trends, predicated upon more momentum investors and trend followers, will be longer and of greater magnitude that previously. The nature of momentum is that it feeds upon itself. It is self perpetuating, self replicating. There are three major implications. First, you need to incorporate momentum into your investment strategy. Second, a momentum based market leaves opportunity for fundamental based value investors. Because the trend goes longer and for a greater duration than fundamental value would indicate, it creates an opportunity for a fundamental based value perspective. Third, turns in the market or changes in trend will trip up a lot more investors. Trend followers, quant or qual, always get burnt by the turns in the market. The length and magnitude of trends will be greater on boths sides of a trend. Significant alpha will come from picking a change in trend. Incorporating a market reversal component into an investment process (albeit incredibly difficult) will be very rewarding.

The old adage, go with the flow will be the dominant characteristic of future markets.

Why jumping on the band wagon is so tough for me

I am a natural contrarian.

I think mean reversion is etched into my DNA.

I also have a bad case of regret embedded within my psyche.

Consequently, jumping on the band wagon aka as trend following or momentum investing really cuts against the grain for me.

I am happy buying when others are selling and then riding it down, and I am happy selling when others are buying and then seeing it continue higher. But I have a hard time bringing myself to buy after the horse has bolted (even if I can see clear air ahead) and selling after a holding has been pinged. The reason is because the regret of jumping on board and being wrong, ie. having the stock go back down, or selling a loser only to see it rise, weighs heavily upon me.

I've got to cure my momentum reluctance. It is not constructive.

High Frequency Trading

The rationale for HFT is couched within the premise that we have a better idea of anticipating the near future than we do the far future. And there is evidence to support that contention.

HFT simply takes that principle (fractals) and reduces it to its logical conclusion (slicing time into its smallest pieces). For any quant pattern recognition/trend following system, the most critical control is downside risk management.