Trend following is the only valid answer to the problem of uncertainty

The most fundamental determining fact in connection with organization is the meeting of uncertainty. The responsible decisions in organized economic life are price decisions; others can be reduced to routine

Frank Knight, “Risk, Uncertainty and Profit”

Over the years I’d written many articles suggesting that price forecasting based on market fundamentals is a waste of time – if not something worse. In polite society, this is not a popular claim, so David Zervos’ recent statement that studying economic data was a “colossal waste of time,” came as a bit of redemption. But while Zervos’ statement (see below) reflects the more recent economic upheavals, I’ve kept a critical eye on price forecasts for over 20 years.

Forecasting the price of oil

Oil is the world’s most closely studied commodity. Every year, the U.S. Energy Information Administration (EIA), publishes an exhaustive report titled “International Energy Outlook” that includes long-term price forecasts from the EIA and a group of the industry’s leading research institutions. In 2003, when the oil price started its remarkable ascent to new historical highs, the EIA two-year forecasts all clustered around the low $20s per barrel:

Subsequently, the EIA changed the way they report their forecasts, projecting a broad high and low price range. With such a broad brush, there would be a better chance of hitting the right answer. But even this approach failed:

EIA’s broad-brush approach (presently as broad as $70/bbl) has been badly wrong almost from the day it was published and it’s been mostly wrong for six years!

Extreme price events: the greatest risk and the greatest opportunity

Crude oil price chart after 2003 shows a sequence of large-scale price events followed by periods of consolidation. Experience has shown that extreme price events represent the greatest source of risk for oil-related businesses. For example, when oil prices collapsed by over 70% from mid-2014 through 2015, the losses sustained by the US mining industry (which includes oil and gas producers) wiped out more than eight previous years’ worth of profits. The 40% price drop in 2018 and the repeat 70% drop in 2020 have also inflicted devastating losses on many industry participants.

Risk = opportunity

What’s important to recognize here, is that risk is the flip-side of opportunity: if extreme price events are the greatest source of risk, they are also the greatest source of potential profit. To take advantage from such events (and to avoid getting crushed by them), market participants need to know how to correctly anticipate them.

“One thing I have learned over time is the best thing to do is let market price action guide your decision-making and then try to understand the fundamentals as they become more evident and comprehensible.”

Paul Tudor Jones (May 2020 newsletter)

Three reasons forecasters fail to predict major price events

There are three key reasons why conventional approaches to market analysis regularly fail to predict major price events:

(1) Availability and quality of data

The way economic data is collected, tallied, interpreted and presented is always a process that can be somewhat complex, that’s based on numerous assumptions, is always error prone to some degree and involves a time delay. As a result, analysts inevitably deal with partial and approximate representations of a given market.

(2) The unit of account conundrum

Prices and forecasts are always expressed in some unit of account – US dollar, yen, euro, etc. This currency is usually assumed to be a solid foundation on which to measure the relative worth of output, consumption and investment. But currency is itself subject to fluctuation and can affect the nominal price of assets and commodities.

Even if the supply and demand of any given commodity were fixed in perfect equilibrium, its price would likely still fluctuate because of the changes in relative value of the currency.

Take the example of oil again. Oil prices are usually expressed in US dollars per barrel. While it would be difficult to measure US Dollar’s impact on oil prices, we can easily measure their correlation. Over the past 20 years, there’s been an almost 80% inverse correlation between the US Dollar Index and the price of crude oil: as the dollar weakened, oil prices have tended to go up and as it strengthened, oil prices tended to fall. The relationship is quite apparent when we plot the two time series together:

Thus, the relative strength of the US dollar has represented the single greatest influence on oil prices. This implies that, to try and forecast future price fluctuations, oil market analysts must also take into account the state of US economy, inflation, Federal Reserve’s monetary policy, government’s fiscal policies, etc. The sheer complexity of these factors’ interrelatedness easily overwhelms anyone’s ability to digest them.

(3) Groupthink among the forecasters

In January 2019, Reuters asked over one thousand energy market professionals to predict future oil prices. These experts thought that the barrel would average between $65 and $70 through 2023, close to where it was trading at the time. Just like the EIA 2003 example, this forecast reflects the groupthink that often prevails among well respected analysts.

Namely, forecasts affect their authors’ reputations. The farther they stray from the crowd, the greater the risk: if they get it wrong, and not just by a little bit, they could be subject to ridicule or worse. Thus, even if in 2003 some bold analyst correctly estimated that oil prices would more than double through 2005, their firm would be unlikely to publish such a forecast. From an institution’s point of view, it’s better to be wrong along with everyone else.

Trend following is the only valid answer to the problem of uncertainty

Given that timing and direction of extreme price events are unpredictable, how can we master the resulting uncertainty and turn this source of risk into profits? The answer lies in the very nature of market price fluctuations.

Extreme price events almost invariably unfold as trends. They can span many months or even years, enabling us to capture value from them using systematic trend following strategies. The chart below shows how I-System strategies performed trading Brent Crude Oil from January 2014:

The above set of 12 I-System strategies (I had used these strategies to trade the Altana Inflation Trends Fund) generated a profit of over $96/bbl from 2014 through 7May 2020. This performance was purely the result of systematic trend following with no need to know anything at all about oil market fundamentals or anything else for that matter.

Trend following works in almost any market

The ability to apply the same set of tried and tested rules in any market represents one of the most valuable advantages of systematic trend following. Transcending the need for industry-specific expertise, trend following enables us to trade across many uncorrelated markets like silver, copper, soybeans, cotton, treasury futures, major equity indices and upwards of 50 tradable FX pairs.

Such diversification may be the only kind of free lunch in investment trading, enabling similar investment returns at lower levels of risk or enhanced returns at similar levels of risk.

Read more about trend following…