Daily Speculations

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Victor Niederhoffer: Trendists versus Reversalists

Returns of trend followers have been very bad. Let's say an average of -20%. And apparently according to Mr. Tar, his friends who are reversalists are making that money. Such seems to go in cycles, but of course this must be proved with survivor adjusted data.

But one wonders aside from the fact that there is a negative serial correlation for all relevant periods for US stock markets, is there any reason to expect one to consistently perform better than the other. One throws out all the promiscuous psycho explanations that those on one side or the other use to justify their a priori feelings as they explain everything and predict nothing before the fact. But one wonders if there is a root cause in that the market prefers the path of least resistance and when it has to use much energy to create frictional losses on the wrong side, this is much more wasteful than backing and filling.

When the market can accomplish its goals simply, is this not much better for the powers that be, the maintenance of the system than one where its necessary to bring the economy into free fall, or the exporters in a certain industry or users of certain energies into dishabille and financial and moral embarrassment. Could this be the reason that for all future periods, the trendists will make their continuing forward looking contributions to markets? Or is it somehow related to any fixed slow-moving participant with the trendists tending to be fixed than the contrarians? What are your thoughts from an economic, from a thermodynamic perspective and does it lead to any interesting predictions going forward, e.g., when structural shifts occur?

Philip J. McDonnell comments:

Traditional economic theory says that when a good is reduced in price the demand increases. That is an axiom which a good economist never doubts. It is as fundamental to the discipline as the principal that the speed of light is a constant would be to a physicist. For speculative markets that economic axiom is deficient in that it only tells half the story.

For two classes of investors whom I would characterize as fundamentalists and contrarians the traditional economic demand function is just as classical economics would have it. These people buy when prices come down to "value" levels and sell when they perceive "overvaluation". With respect to these people I have no disagreement with traditional economic theory.

However there is another strange beast who flourishes in speculative markets (and rarely elsewhere!). This class of traders I would classify as trend followers. They prefer to buy only after the price has risen, they prefer to sell only after the price has fallen. Their belief system is that trends will continue and that they wish to profit from such continuation. To this extent they change the character of speculative markets in a very fundamental way.

In effect the trend following class provides a second demand function which only comes into play when prices rise as opposed to the traditional demand function which is under the current market. On the other hand trend followers create a second supply function which comes into play below the current market price in contrast to the traditional supply function which exists only above the current market.

My theory is that for speculative markets there are two demand functions one below the market caused by fundamentalists and contrarians and a second demand function above the market which serves to accelerate rising price movements. There are also two supply functions one, the traditional fundamentalist and contrarian supply above the market. The other is a supply function created by trendists who either perceive falling prices as the beginning of a new down trend or are protecting positions via stop loss selling. The trendists supply function is below the market and most importantly is sloped opposite to the supply of the fundamentalists and contrarian supply function. I would make the same observation with respect to the demand function of the trendists. It is both above the market and has a slope of opposite sign to the traditional economic assumptions. Thus trendists tend to accelerate movements and fundamentalists/contrarians tend to limit such movements.

I believe that the existence of the trendist supply and demand functions is the salient feature of speculative markets which traditional economists have missed up to now. It is the driving force behind the reality that "the market will fluctuate".

George Zachar Comments

Victor Niederhoffer wrote, "when the market can accomplish its goals simply, is this not much better for the powers that be, the maintenance of the system ..."

If one posits that the mistress' fundamental purpose is funding her own maintenance, why not reverse engineer that?

Certainly the current orgy of technology spending by the street, coupled with the collapse of the commission structure, the rise of various non-floor networks, the elimination of so many middle-men, etc., etc., all offer us a glimpse inside the wench's expense kimono.

Does the new meta-structure of the market itself give away her most profitable scheme?