The Non-Random Walk Theory - Persistency
by Damian
Campbell
Published on this site: March 25th, 2006 - See
more articles from this month
Non-Random price behavior is not a myth. It exists and if you are not exploiting
it you should be. Here is a closer look...
The CET Capital investment strategies
aim to exploit persistent price behavior of the small cap stock indices and mutual
funds. While some of CET Capitals' methodologies are proprietary, exploiting persistent
price behavior; which is the foundation of what we do is not. Persistency, as
defined by Gil Blake, is a
combination of volatility and historical reliability.
Below I will summarize an interview in Jack Schwagers' book, The New Market Wizards,
which eloquently describes how in the 1980's a successful money manager named
Gil Blake capitalized on persistency. My aim is to demonstrate two ways of identifying
non-random, persistent price behavior. The first will describe non-random
price behavior in terms of probability. The second will show persistency in terms
of compounded annual return and drawdown. My goal is to convince you that exploitable
persistent trends have existed as far back as your grandparents can remember and
they exist today. Simply put, you should be invested with a
manager who exploits
these trends.
The History of Persistency.
Gil Blake was one
of the first money managers to exploit non-random price behavior and talk about
it. Below is a summary of his interview from Jack Schwagers' book The New Market
Wizards. The chapter is called "Gil Blake: The Master of Consistency".
Gil
Blake was a mutual fund timer who was able to achieve gains of over 20 percent
per year. Blake's life changed in the early 1980's when a friend presented him
with evidence of non-random market behavior. When choosing which mutual funds
to trade he "would rank each sector based on a combination of volatility
and historical reliability, which he called persistency". He became so confident
in monetizing these persistent trends that he took out four successive mortgages
on his house over a three year period so he could invest more money in his strategy.
When he started to examine managed sector funds he was amazed "that the daily
average price change in a given sector had anywhere between
a 70 percent to
82 percent chance of being followed by a move in the same direction the following
day." One of the things that Blake said was, "If the odds are 70 percent
in your favor and you make fifty trades, it's very difficult to have a down year".
His high trading frequency eventually got him banned from Fidelity
and was
also a large influence on the introduction of what are now known in the mutual
fund industry as early redemption fees. His successes were also a tremendous influence
on CET Capital. I want to note here that with the introduction of high beta inverse
mutual funds from fund families like ProFunds and Potomac hedging can be used
instead of selling. As of March 2006 CET Capital is trading a short term strategy
which incorporates hedging instead
of selling, therefore actively trading
these managed mutual funds is now once again possible.
Analyzing Persistency
A
more familiar way of looking at "Persistency of Price" (POP) is to think
of it in terms of "winning streaks". Below POP is shown for consecutive
up days ranging from two days (POP2) to six days (POP6) for three of the major
US indices.
[image:
http://www.cetcapital.com/images/clip_image002.gif ]
[image subtext:]
Start date of analysis: September 9, 1988.
End date of the analysis:
December 30, 2005. Statistics were compiled using FastTools analysis software
and FastTrack data.
Simply put the Russell 2000 is the most persistent
index in this group. An up close has a 62 percent chance of being followed by
an up close in the same direction the following day (POP2), while the probability
of having three up closes in a row is 39 percent (POP3). Like Blake, I look at
it is like this, if you are
trading something that has a 62 percent probability
of closing up tomorrow if today is an up day and you are making between forty
and sixty trades per year it will be difficult to have a down year.
Therefore
if you simply buy on an up close and sell on a down close in the long run you
capture the heart of the price move and beat buy and hold. Below there are two
sets of charts which compare trading for persistency vs. using the buy and hold
approach of the respective index from its inception. The top group of charts is
thumbnails and will open to bigger charts if you click on them. These charts represent
the simulated compounded growth of a $1000 using the above simulation rules for
the S&P 500, NASDAQ 100 and our trading vehicle of choice the Russell 2000.
The bottom table takes a closer look at each strategies compounded annual return
(CAR), maximum drawdown and ulcer index (UI).
Trading for Persistency
vs. Buy & Hold
Growth of $1000
NASDAQ 100
[Image:
http://www.cetcapital.com/images/NDX-vs-Persistency.gif
]
Russell 2000
[Image: http://www.cetcapital.com/images/RUT-vs-Persistency.gif
]
S&P 500
[Image: http://www.cetcapital.com/images/SPX-vs-Persistency.gif
]
A closer look at the statistics behind the strategies.
[Image:
http://www.cetcapital.com/images/Persistency_Table.gif
]
In each of these examples trading for persistency blows away buy &
hold. Historically, using this simple approach not only increases your compounded
annual return it reduced drawdown significantly. The point I want to drive home
here is short term trading for persistency works and it works better on the more
persistent indices (Russell 2000) then the less persistent indices (S&P
500), hence why CET Capital trades the Russell 2000. The point is you should have
a manager who focuses on persistency in your portfolio.
Note: CET
Capital uses this short term trading approach as one of our triggers in all of
our Short Term strategies. We have also identified periods of time in which the
markets are more persistent. Our job is to sit on the sidelines when the day to
day consistency of the market is low and invest when it is high. To further capitalize
on market persistency we have identified the best periods of time in which to
use leverage.
Damian
Campbell is President and head money manager of CET Capital, a Registered
Investment Advisory firm. He oversees the testing and execution of all CET Capital
investment programs. Low Minimum, Low Management Fee, Small Cap Focused, No Leverage.
Please visit us on the web at http://www.cetcapital.com
or call.
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