(For an audio reading of this post – with some extemporization, go here)
Good trading acknowledges that we cannot know the future. The best we can hope for is to follow the time-honored discipline of riding trends while cutting losing positions. The fact that this method has worked for so long on so many different markets is proof enough that prices are not truly random, but that the future is somewhat influenced by the past. The “somewhat” here is important to remember – a good trader or investor doesn’t predict the future – he merely exploits a statistical edge.
But what is this edge academics dryly call the momentum factor? On medium to long-term time scales (3-24 months), a price vector is somewhat more likely to continue than to revert. But what is happening here? Humans herding, yes, but it goes deeper. Price movements reflect feedback loops, whereby good outcomes and good vibes beget more of the same. Robert Shiller grapples with the idea through the framework of narratives. The esoteric Soros coined the word reflexivity. What we’re talking about is a cornerstone of chaos theory, humanity’s current working model for understanding the world.
In 1997, Steve Jobs returned to a struggling Apple, and his vision and charisma spun up a vortex that birthed the iMac, iPod, and Apple Stores. He created a nearly self-sufficient universe of products, customers, and investors. I remember discussing Apple in a business school class circa 2004. I was skeptical of the iPod, which seemed to me just a hard drive and set of headphones, hardly a moat against competitors. There was no MacBook Pro, the iBook didn’t have much market share, and the iPhone was just a vision in Job’s head. The stock was a split-adjusted $1.50, still 50% below the 2000 highs.
Not even the most dedicated proto-fanboy would have made the case that Apple would be the first trillion dollar company. But invention and growth created excitement and attracted talent and capital. The stock had gone up by an order of magnitude by the launch of the iPhone in 2007, as the vortex drew in still more customers and a whole community of developers for the App Store. Success begat confidence, exuberance even, as serotonin and dopamine bonded together what could truly be called a community or even movement, replete with proselytizing geeks and bloggers.
The Apple story is one of lasting success, but such charisma and idea-driven vortices don’t always find a way to sustain themselves. Sometimes the charismatic leader is a fraud, as with Theranos, and sometimes the idea just doesn’t work as well in reality as in theory, as with MoviePass. Sometimes a hard look can reveal the truth, as when Harry Markopolous figured out Madoff in 2000, but often the future is completely unknowable, as it depends on the whims of the crowd or other forms of luck.
What is salient for us is that there is no way to know the future, though we often feel in retrospect that we saw it coming. When we invest, we are making decisions in chaos, as mass human behavior is no more predictable than the weather. But when you see a tropical depression of increasing intensity, it has a greater chance of becoming a hurricane than one that is dissipating into a mere rainstorm.
Such vortices may be companies, industries, or whole investment themes encompassing entire geographic regions or multiple asset classes. Once in motion, they can be provisionally expected to stay in motion, and their eventual intensity often surprises us. Do not count on this by any means, but don’t stand in the way.
Finally, when you think about trends as complex feedback loops, you realize that they can’t be arbitraged away, as no one knows the future. Respect them and learn to ride them, but gingerly, as you might a tiger.