Quantitative Momentum. Vogel Jack R.
in turn, provided protection for agricultural land. Rice was the largest crop at that time, accounting for as much as 90 percent of government revenues, and became a staple of the Japanese economy.
The important role of rice in Japan led to the establishment of a formal exchange in 1697, and eventually to the emergence of what many believe to be the first futures market, the Dojima Rice Market. That market grew to include a network of warehouses, with established credit and clearing mechanisms.5
The rapidly evolving rice market in Japan was the fertile financial environment in which a young rice merchant, Munehisa Homma (1724–1803), found himself during the mid-1700s. Homma began trading rice futures and used a private communications network to trade advantageously. Homma also used the history of prices to make predictions about the direction of future prices. But his key insight involved the psychology of the markets.
In 1755, Homma wrote, The Fountain of Gold – The Three Monkey Record of Money, which described the role of emotions and how these could affect rice prices. Homma observed, “The psychological aspect of the market was critical to [one's] trading success,” and “studying the emotions of the market…could help in predicting prices.” Thus, Homma, like de la Vega, was perhaps one of the earliest documented practitioners of behavioral finance. His book was among the earliest writings covering markets and investor psychology.6
Homma invested on the long and the short side, and was thus an antecedent to today's hedge funds. He was so successful and became so wealthy that he inspired the adage: “I will never become a Homma, but I would settle to be a local lord.” He eventually became an adviser to the government, and to Japan's first sovereign wealth fund.7
On the other side of the globe, financial markets were also evolving. The late nineteenth and early twentieth centuries marked a time of increasing stock market participation in the United States. Among the most famous equity investors of that era was a man named Jesse Livermore. He began trading at the age of 14, and over his lifetime, he gained and lost several fortunes.
An American author named Edwin Lefevre wrote the biography Reminiscences of a Stock Operator. The biography is an account of Livermore's life and experiences in the early years of 1900s. The book describes Livermore's success using technical trading rules. Lefevre also described Livermore's overarching philosophy on the market:
You watch the market…with one object: to determine the direction – that is the price tendency…Nobody should be puzzled as to whether a market is a bull or a bear market after it fairly starts. The trend is evident to a man who has an open mind and reasonably clear sight…8
We gain more insight into Livermore's investment philosophy when we examine comments regarding his buy and sell decisions. We would recognize these decisions today as modern “momentum” strategies: “It is surprising how many experienced traders there are who look incredulous when I tell them that when I buy stocks for a rise I like to pay top prices and when I sell I must sell low or not at all.”
Clearly, the ideas that investors are not completely rational, and prices are related to future prices are not new ideas. Collectively, the investors discussed above – Joseph de la Vega, Munehisa Homma, and Jesse Livermore – highlight how great investors across history have recognized the role of psychology in the markets, and that historical prices can help predict future prices – in other words, technical analysis works. But fast forward to the early twentieth century, when some investors began to question whether technical analysis represented a sensible approach to investing. Many thought analysis of a company's fundamentals might be a more reasonable technique. Investors began to investigate fundamental analysis, involving a careful review of a company's financial statements, in hopes that such analysis might provide a better rationale for making investment decisions. In particular, a new investing philosophy began to gain notoriety: value investing, which involves buying stocks trading at a low price versus various fundamentals, such as earnings or cash flow.
Benjamin Graham is commonly known as the father of the value investing movement. Graham believed that if investors bought stocks at prices consistently below their intrinsic value, as determined by fundamental analysis, those investors could earn superior risk-adjusted returns. Graham outlined his value-investing framework in two of the most famous investing books of all time, Security Analysis and The Intelligent Investor.
Graham realized that there were many adherents to the technical analysis approach, but he was clear in expressing what he thought of the discipline: bogus witchcraft. A quote from The Intelligent Investor summarizes his views:
The one principle that applies to nearly all these so-called “technical approaches” is that one should buy because a stock or the market has gone up and one should sell because it has declined. This is the exact opposite of sound business sense everywhere else, and it is most unlikely that it can lead to lasting success on Wall Street. 9
Graham's early criticism of technical analysis has been reinforced over time by other adamant adherents of the fundamental analysis religion. Graham's most famous protégé, Warren Buffett, took the boxing gloves from Graham and continued to beat on the technical analysis crowd. A statement attributed to him demonstrates his views: “I realized technical analysis didn't work when I turned the charts upside down and didn't get a different answer.” A more recent quote by Burt Malkiel, who penned the popular book A Random Walk Down Wall Street, brings the disdain for technical methods front and center: “The central proposition of charting is absolutely false…”10
One can almost hear the laughter from the fundamental analysts. They believe they are better informed and ultimately more rational than technical investors. Another statement attributed to Buffett is, “If past history was all there was to the game, the richest people would be librarians.” It's pretty obvious that, in Buffett's view, only obscure and harebrained librarians turning their charts around and around would ever consider technical analysis to be a legitimate discipline. And perhaps the religious adherents of the fundamental approach thought that the use of humor and ridicule would make their arguments more compelling.
More recently, Seth Klarman, the billionaire founder of the Baupost Group hedge fund, has also denigrated technical analysis. In his cult-classic value investing book Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, Klarman is clear about his views:11
Speculators…buy and sell securities based on the whether they believe those securities will next rise or fall in price. Their judgment regarding future price movements is based, not on fundamentals, but on a prediction of the behavior of others…They buy securities because they “act” well and sell when they don't…Many speculators attempt to predict the market direction by using technical analysis – past stock price fluctuations – as a guide. Technical analysis is based on the presumption that past share prices meanderings, rather than underlying business value, hold the key to future stock prices. In reality, no one knows what the market will do; trying to predict it is a waste of time, and investing based on that prediction is a speculative undertaking…speculators…are likely to lose money over time.
It is illuminating that Klarman views underlying fundamentals as the only justifiable signal for insight into future stock prices. Price action is “meandering” and meaningless, and efforts to predict the behavior of others are in vain. But Klarman doesn't stop here. He goes on to reject any systematic means of predicting future stock prices:
Some investment formulas involve technical analysis, in which past stock-price movements are considered predictive of future prices. Other formulas incorporate investment fundamentals such as price-to-earnings (P/E) ratios, price-to-book-value ratios, sales or profits growth rates, dividend yields, and the prevailing level of interest rates. Despite the enormous effort that has been put into devising such formulas, none has been proven to work.
It
www.ndl.go.jp/scenery/kansai/e/column/markets_in_osaka.html, accessed February 15, 2015.
Jasmina Hasanhodzic, “Technical Analysis: Neural network based pattern recognition of technical trading indicators, statistical evaluation of their predictive value and a historical overview of the field,” MIT Master's Thesis (1979). Accessible at hdl.handle.net/1721.1/28725.
Steve Nison,
Edwin Lefevre and Roger Lowenstein,
Benjamin Graham,
Burt Malkiel,
Seth Klarman,