Trend v. Countertrend

Nov. 2, 2022

Countertrend trading feels like the right thing to do.

After all, what’s more logical than buying something on sale?

Looking for value will never go out of style.

But does it produce profit?

Of course, the first answer is: Of course! Just look at Warren Buffett. His company is almost worth more than Tesla now and he’s the wisest man in investing.

And he “buys when others are fearful”, the epitome of trading against the trend.

Hmm.

In the famous book, How I Made $2 Million in the Stock Market, Nicolas Darvas also believed in counter-trend trading (even though Warren wasn’t Warren yet). He believed in it because it made sense.

It just didn’t make any money.

Darvas lost money being a fundamentally-based value investor. And got discouraged. He didn’t make his $2 million until he started following the trend.

In the early 2000s, my buddy asked me if I wanted to compete in a “stock trading contest”. Just me and him, mano a mano. We’d pick a stock each month and then see which pick went up the most in 30 days. We’d keep track of each month’s winner and the overall champion for the year would take the other to dinner.

So we started, but it wasn’t fair. I had been reading Warren Buffett books for months and I had a subscription to Morningstar and their fabulous 5-star ratings. I knew how to buy things on sale and my buddy didn’t. I could already taste the appetizers.

How did it go?

I got killed.

It turns out he was picking growth stocks in the IBD 50 while I was picking 5-star value stocks that were down on their luck. And it wasn’t close.

So, because I was maniacally competitive back then, I threw everything out the window and started choosing growth stocks.

How did it go then?

I dominated. I won so much that we stopped doing the contest. At least, I think that’s why we stopped. (He might disagree!) Whatever the reason, after collecting my year-end prize, we never did the contest again.

As soon as I stopped picking value stocks, I made money.

Another famous book that’s one of my all time favorites is The Little Book That Still Beats the Market. It’s wonderfully written and makes an unassailable case for the power of value investing. And it gives an accessible value investing formula to screen value stocks called the Magic Formula.

It was so well-written and compelling that I started tracking a Magic Formula value investing portfolio every year going back to 2006.

How has it done?

Okay, I guess.

Since the massive bull run from 2020-now, the Magic Formula portfolio is up 14.5%:

While it’s not negative, it’s worse than the S&P 500. And it’s done worse than the market for several years now.

And it doesn’t come even close to the triple-digit plus returns trend followers put up from 2019-2021.

Psychologically, it feels like a wonderful, warm blanket to buy things on sale.

The examples of countertrend trading doing poorly, though, are all over the place.

In our next Newsletters, we’ll examine some actual numbers. We’ll directly compare a trend and a countertrend system.

I wonder who will win.

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Disclaimer:
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.