Monday, August 9, 2010


I have a quiz question for you. If you are an investor using the trend-following technique, you believe the trend is your friend. One of many methods used to identify a trend is to add up the past twenty, fifty, and two hundred days of prices, and then average them out in order to see if the moving average of price is trending either up or down. You then use this information to make a forecast about the future direction of the market, which you expect to continue in the direction of the trend. On the other hand, what if you use the mean reversion technique? Practitioners using mean reversion add up enough past price data to establish the average, or mean, price and then watch to see if the market is drastically diverting from the norm. If the price gets to two or three standard deviations from the average, you could be either a buyer or seller depending on whether current prices are above or below the average. If you practice mean reversion, the trend is definitely not your friend since you are betting that the trend will reverse to the mean or average of the past. Once again, mean reverters use past data to formulate a forecast of future market direction. So…which of these strategies is more “forward looking?” I’m guessing the answer is mean reversion, if only because the strategy requires the investor to execute transactions in anticipation of a market reversal, instead of waiting for the actual market reversal required by trend followers. Both strategies have obvious risks. For trend followers the risk is that the trend reverses and you are whipsawed in or out of the market in a trendless market. For mean reverters the risk is that the trend continues long past the point that standard deviation says it should. Or, there is a structural change in the market that changes the mean going forward.

How about traditional value investing? Traditional estimates of market value depend on forecasts of future cash flows, dividends, and earnings and discounting them at current interest rates to determine a “fair value” for a market or a security. I suppose you can’t get more forward looking than that. On the other hand, Pinnacle also studies measures of market value based on the average of five and ten years of past earnings. This method still requires investors to execute transactions in advance of a market move, but the data used to make the forecast certainly isn’t forward looking. Another important aspect of Pinnacle’s investment process is to analyze the global economic environment. One part of that decision making process is to analyze the Conference Board’s leading economic indicator, as well as the ECRI (Economic Cycle Research Institute) leading indicators, the OECD leading indicators, and a variety of market leading indicators including copper, commodity, and shipping prices. However we also look at numerous coincident indicators and all of the above are often compared to the data points of the past.

All of which is to say that Pinnacle is often forward looking in our investment process…which has its own set of risks and rewards. We recognize these risks by making small changes to our portfolios as the data is evaluated in real time. The natural result of the process is to avoid large asset allocation bets because we are often working in advance of actual changes in market trends. Investors are well-served because we have no philosophical problem marrying trend-following and mean-reversion in our decision-making process. Perhaps our biggest problem is trying to explain all of this in a simple way to Pinnacle prospects.