Anderson What Moves The Market Manual

Profiting from the Market’s Two-Sided
Nature
Presented by
Gary Anderson
Anderson & Loe, Inc
gary@EquityPM.com
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“In some seasons trend following is
good; in others, reversing is good.
The problem is how to differentiate
the two seasons in advance.”
Victor Niederhoffer, The Education of a Speculator
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1. Two sides of risk
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2. A binary method of
calculating relative strength
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2. A binary method of
calculating relative strength
3. Feedback Systems
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1. The market as a system
of capital flows
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of capital flows
2. How the system works
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of capital flows
2. How the system works
3. How to work the system
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DEFENSE
The defensive qualities of a

stock/group are most severely
tested during periods of market
weakness, when the risk of loss
is most acute.
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OFFENSE
Since the risk of lost opportunity

is greatest as the market rises,
the offensive qualities of a
stock/group are best measured
as the market advances.
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Feedback Systems
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How Feedback Generates
Systematic
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Positive Feedback
Traders buy into strength and
sell into weakness.
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Negative Feedback
Traders sell into strength and
buy into weakness.
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Beta
Relative Volatility
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Alpha
Return in excess of a benchmark
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In a strong, momentum-driven
market, traders express confidence
by seeking both Alpha and Beta,
and by shedding low-Alpha, low-
Beta groups and stocks.
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Expansion and Contraction
create two distinct market
environments.
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Expanding Universe
Positive Feedback Creates Momentum
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Momentum-Driven
Markets
Traders have confidence in price direction
Traders buy into strength and sell into
weakness
Trends develop and persist
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“It takes confidence to buy into strength
and to let profits ride. When traders, for
whatever reasons, gain confidence in a
bullish trend, they defer profits and chase
strong stocks into new high ground.
Stocks that do not participate in the trend
are ignored or sold. Trends accelerate,
and profits, for those trading with the
trend, come easily.”
The Janus Factor63

“On the other hand, when traders are
confident of a bearish trend, the weakest
stocks are liquidated or shorted
aggressively, and proceeds are held in
cash or shifted to stronger stocks that
defend well in a falling market. Trends are
durable, albeit negative, and traders
willing to sell into the trend are rewarded.”
The Janus Factor
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“Trading strategies that buy past
winners and sell past losers realized
significant abnormal returns over
the 1965 to 1989 period.”
Jegadeesh and Titiman, “Returns to Buying Winners and Selling
Losers: Implications for Stock Market Efficiency”, 1993
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J&T’s Data Set
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“The historically strongest stocks
produced the best future results
and the historically weakest stocks
produced the worst.
Robert Levy, The Relative Strength Concept of
Common Stock Price Forecasting, 1968
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Levy’s Data Set
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“When I see by my records that an
upward trend is in progress, I become a
buyer as soon as a stock makes a new
high after a normal reaction. The same
applies [in reverse] whenever I take the
short side. Why? Because I am following
the trend at the time. Never buy on
reactions or go short on rallies.”
Jesse Livermore, How To Trade In Stocks, 1940
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Contracting Universe
Negative Feedback - No Momentum
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Non-Momentum
Markets
Traders are risk-averse
Traders sell “expensive” stocks and
buy sold out “bargains”
Trading is range-locked or corrective
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“The dynamic is quite different once
traders lose confidence in the trend.
Risk-averse and contrarian, traders
respond negatively to price change.
Buying is focused on oversold
“bargains”, and profits are taken in
stocks that have rallied. Trends are
short-lived and unreliable, and
profits are elusive.”
The Janus Factor

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“As Fama and French (1988) and
others have noted the market was
extremely volatile and experienced a
significant degree of mean reversion
in the 1927 to 1940 period.”
Jegadeesh and Titiman, 1993
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Beginning in 1932, Harold M. Gartley
popularized the use of relative
strength for analyzing industries or
groups of stocks. James Alphier wrote
that Gartley, who had pioneered
relative strength to study stock groups,
abandoned its use in the 1930s and
1940s because it did not work.
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“As Fama and French (1988) and
others have noted the market was
extremely volatile and experienced a
significant degree of mean reversion
in the 1927 to 1940 period.”
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Contrarian Market
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“Following a 40% decline in the index over
the previous 6 months, the index rebounded
with a 43% increase in July 1932. The
relative strength portfolio experienced a
negative 40% return.
In the following month, the index increased
another 66% and the RS strategy lost 68%.
In the 1930s there were 4 other months in
which the strategy lost over 40%. Each
occurred when the market increased
substantially.”

80
“In a narrow market, when prices are not getting
anywhere to speak of but move within a narrow
range, there is no sense in trying to anticipate
what the next big movement is going to be, up
or down. . .
Those were the lean years, 1911-1914. The

market flattened out. Things drifted from bad to
worse. I not only lost all I had but got into debt
again. There was no money to be made.”
Jesse Livermore, Reminiscencs of a Stock Operator (Lefevre)
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Daily
20
00
DowIndustrial Average
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20
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“In some seasons trend following is
good; in others, reversing is good.
The problem is how to differentiate
the two seasons in advance.”
Victor Niederhoffer, The Education of a Speculator
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The
Spread
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An expanding (rising) Spread is
the result of positive feedback
and indicates momentum.
Trend Followers are in control.
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A contracting (falling) Spread
is the result of negative
feedback and indicates a lack
of momentum. Contrarians
are in control.
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A change in the direction
of the Spread indicates a
paradigm shift as well as
a change of control.
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Are Markets Predictable?
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Skeptics’ Argument
The market is driven by news, and
news is, by definition, random.
Since market behavior is random,
price analysis has no (predictive)
value.
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Price action is also news.
By their collective response to
that news, traders forge causal
links between past price data
and current price movement.
Price data are linked because
traders link them.
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Feedback produces
Complex, Self-organizing
systems
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Complex:
Random, exogenous information is
introduced into the system which
directly affects local variables.
Self-Organizing:
Feedback produces systematic--
endogenously generated, orderly
outcomes--which may be observed
in global behavior.
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Complex, Self-organizing
Systems
Schools of Fish
Flocks of Birds
Herds of Animals
Markets of Traders
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Since no two traders face the
same complex of interdependent
local and global conditions, there
is no single set of initial conditions
from which traders’ aggregate
behavior may be deduced.
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“Particularly in cases where there
are random inputs, even if we
understand dynamical reasons,
there is no chance of computing
and determining the future.”
Klaus Mainzer, Thinking in Complexity
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Because complex systems are
computationally irreducible,
future states are incalculable.
What we can do is note the
evolution of the system and
continuously test to determine
the profitability of emerging
rule-sets.
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“It is not the strongest of the
species that survives, nor the
most intelligent, but the one
most responsive to change.”
Charles Darwin, The Origin of Species
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“You can only see as far as your
headlights . . . but you can make
the whole trip that way.”
E.L. Doctorow
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The spontaneous emergence of
extreme events in self-organizing
systems is the result of positive
feedback.
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The Edge
Positive Feedback Tends to Persist
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Working the System
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There are two sets of rules:
- Trend Following
- Contrarian
Which is Dominant?
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After extensive studies, Norman G.
Fosback wrote in Stock Market
Logic (1976) that relative strength
is “a valid stock selection tool less
than half the time.”
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1987 thru 1999 2000 to Present
Rising Spread 53% 53%
Falling Spread 47% 47%
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Momentum
vs.
Price Trend
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All momentum-driven markets
are trending markets.
But not all trending markets are
momentum-driven.
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The Watermelon
Strategy
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Alpha-producing, trend-
following strategies work
during momentum-driven
periods, when the Spread
is rising.
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A Momentum-Based Strategy
Emphasizes Focused Selection,
not Timing
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Strategic Elements
1. Direction of The Spread
2. Direction of the Trend *
* RS Leaders
* RS Laggards
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Momentum
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1. Focused Long
If the Spread is rising, and

both relative-strength leaders
and laggards are rising, then
buy the strongest stocks in
the strongest groups.
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Rising Spread
Rising Market 29% 20%
Mixed, Flat Market 11% 19%
Falling Market 13% 14%
Total 53% 53%
Falling Spread
Total 47% 47%
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2. Focused Short
If the Spread is rising, and

and laggards are declining,
then short the weakest stocks
in the weakest groups.
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Rising Spread
Total 53% 53%
Falling Spread
Total 47% 47%
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3. Focused Long/Short
If the Spread is rising, and relative-

strength leaders are rising and RS
laggards are declining, then buy
strong stocks from the strongest
groups and short weak stocks from
the weakest groups.
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Rising Spread
Total 53% 53%
Falling Spread
Total 47% 47%
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Trends w/o momentum
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1. Indexed Long
If the Spread is falling, and
and laggards are rising, then
index longs.
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Rising Spread
Total 53% 53%
Falling Spread
Total 47% 47%
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2. Cash
and laggards are declining,
then the odds favor cash.
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Rising Spread
Total 53% 53%
Falling Spread
Total 47% 47%
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No trend, no momentum
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3. Cash
relative-strength leaders are
falling and RS laggards are
rising, then goto cash.
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Rising Spread
Total 53% 53%
Falling Spread
Total 47% 47%
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Cautionary Postscript
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equityPM
Advisory For The Equity Portfolio Manager
gary@equitypm.com
143

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Profiting from the Market’s Two-Sided

The defensive qualities of a

Since the risk of lost opportunity

Return in excess of a benchmark

The Janus Factor63

The Janus Factor

Jesse Livermore, How To Trade In Stocks, 1940

The Janus Factor

Jegadeesh and Titiman, 1993

Jegadeesh and Titiman, 1993

Those were the lean years, 1911-1914. The

Jesse Livermore, Reminiscencs of a Stock Operator (Lefevre)

Positive Feedback Tends to Persist

If the Spread is rising, and

If the Spread is rising, and

If the Spread is rising, and relative-

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