Problems in Trend Following (The Impact of Market Manipulation)

For decades, there have been some reliable signals indicating new or changing trends. There have been hundreds of different books sold describing these parameters, and computers programed to trade when trends emerge or fail. This created the ultimate problem, every good technician knows the signals.

The fundamental basis of the signals is built upon the idea that these signals occur because more investors have decided that the price of a certain stock, bond or commodity does not reflect the future business trends and buy (or sell) on the assumption a new valuation is warranted.

In the last thirty years, large pools of money have been created to follow the signals and track the emerging trends both up and down. However, in the past fifteen years hedge funds have sought to take advantage of these investors by using their assets to create “false signals.” For example, if a stock may have spent weeks consolidating in a sideways range, a “breakout” from that range to the upside would imply something fundamental has changed, and trend following investors should buy the stock. However, a large hedge fund may buy additional stock when the issue is at the top end of its range and move the price up to the point where the trend followers begin to buy and those who sold the stock short expecting it to fluctuate back to the lower end of the range would be forced to cover their short positions. The hedge funds actions are designed to create a false “buy” technical signal.

With the natural sellers absent and new buyers coming in, the hedge fund that manipulated the price to generate the signal would then sell their recently bought stock and short additional shares. Their goal is to profit when investors realize there is no fundamental reason for the stock to have risen in the first place, ceasing to buy and further liquidating their recent purchases, accelerating the downward pressure.  In the following example, one can see the break to new highs followed by a sharp decline.

There are more aggressive examples of manipulation that involve post and pre-market trading. Many investors are not aware that hundreds of stocks trade after the market closes and before it opens…commonly called after-hours and pre-market trading. Volume is generally much lower than trading in normal hours. This is fallow ground for manipulation and it is based on creation of fear and generally not fundamentals. And the price movements can be huge. Let’s take the case of Ambarella (AMBA), a stock we own in several portfolios. AMBA has been growing at double digit rates for several years. In the most recent quarter, it exceeded analysts projections…what happened? The stock fell nearly 20% and the fall was preceded by selling which drove the price down in the after hours and pre-market trading.

As you can see in the above chart, AMBA stock had been pushed up through the recent range to new ten-week highs in the days just before the earnings announcement. If we could see the initial response of traders in the after hours, we would see the stock spike up over $56 as one might expect from a positive report, but overnight the traders trashed the stock causing it to be projected lower at the opening, and it did open down 15%. From there panic selling ensued and the manipulators were able to cover their shorts as the stock bottomed near $40.

One might opine, that if such price action was not based in fundamentals, the stock should bounce right back, but that is not how human nature works. When this type of market action occurs, the stock is “busted”… “Severe technical damage” has occurred. Further, analysts and commentators search for fundamental reasons for the decline, writing negative reports or negatively tilted reports to appear knowledgeable. As far as the average investor is concerned, they lost money on the stock and will rarely revisit it. Further, client of money managers will often avoid such a stock after a loss, because 1) they do not want to remind clients of their loss, and 2) they do not want to field questions like, “You just sold that stock at a loss, so why are you buying it again?”

Over time, the fundamentals will prove the price, but an issue can be “out of favor” for a while. Resmed, the issue charted below is repeatedly manipulated around their quarterly earnings reports. The blue lines are reporting days. One can see that it takes some time for the stock to recover.

What are the implications of this phenomena?

First, it makes short term trading even more unprofitable. So, all of those who think they can beat the market by using technical tools are likely going to more quickly transfer their wealth to the professionals. Secondly, it makes using “stops” either entered as orders or mental stops, impractical. Numerous services employ 25% stops for their recommendations and are now being triggered out of the business. Everyone knows where those stops lie and large hedge funds will reach for them to trigger additional selling and profits on their positions. Thirdly, it changes the parameters one uses when entering a position. No longer is it wise to wait for the breakout/breakdown for an efficient entry point. It is better to look for the manipulation and use it to enter the position. And, finally, the emphasis has to be on getting the fundamentals right long-term…on anticipation, not reaction.

One final reflection, one should expect their portfolio performance to be more volatile and less likely to track the broader markets in the short-term (a quarter or a year). Surges in performance will be less predictable. And those who try to position themselves to match the indexes will be relegated to mediocre performance.

We suspect that the destruction of the classic technical trader will ultimately lead to more value-added for the discipline fundamental investor…the performance will just come in spurts rather than smooth trends.

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