Feedback Loops and Sucker Trades

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  • on November 12th, 2011

“Traders’ response to the global behavior of the system produces feedback which is either positive or negative.  Positive feedback is constructive of trends, while negative feedback inhibits trend formation.”  Gary Anderson on Relative Momentum

The biggest mistakes I’ve ever made have involved applying relative strength when conditions demanded ignoring it.  Knowing whether we’re in a positive or negative feedback loop is equally, if not more, important than knowing whether we’re in an up or down phase.  Before we ever consider whether to follow a trend, the question should be “Is this a market that rewards or punishes trend following?”

In my mind, Mr. Anderson has done the best job explaining the difference…the most vivid image for me is that of a spreading fire(positive feedback) vs. a thermostat(negative feedback).  The first expands the energy, the second contracts it.  Imagine a room whose temperature has fallen from 72 to 68…knowing if the heat is set to kick on below 67 is the difference between following or fading(or ignoring) this clearly falling “trend”.

Thanks to glowing praise of his work by Linda Raschke, I just became aware of a newer paper he released ahead of his forthcoming book on Relative Momentum.  I’ve previously recommended his paper Janus Factor; his newer one repeats the same themes but adds depth and measurement to how he distinguishes between positive and negative feedback loops.  Following is a money quote from the 2011 paper:

“Once traders lose confidence in the immediate direction of price, the dynamic changes.  Now risk averse and contrarian, traders take profits quickly in stocks that have rallied and focus bids on fallen laggards.  During periods of contrarian control, price trends are short-lived, and profits become elusive.  Contrarian periods lower traders’ expectations/confidence and set the stage for the next period of expansion.”

Sound familiar?  Whether you call it a ginormous range or sawtooth lunacy or a negative feedback loop, it’s been a few months of sucker trades and I’ve been guilty on more than one occasion.  How about this for another money quote:

“Entropy is the propensity for differences to collapse toward equilibrium, for structure to decay, to incline toward disarray, disorder, and degeneration…an increase in entropy implies an increase in randomness, that is, a decrease in information and, thus, a decrease in confidence with respect to outcomes.”

How about simply remembering to look at Column B before extrapolating Column A into C?

 This is where we can take a page from Joe Fahmy.  He says the market is healthy 2-3 times/year, and is patient enough to wait for his sweet spot quadrant(see C2 above) and ignores the other 3.  We may or may not decide we’re capable of stepping away for months as he does; if not, we’d better have something in place to shift styles and/or timeframes.

This is where I find Anderson’s work most helpful, as a tiny insight on a better way to measure momentum spreads is now providing breakthrough on a project I’ve been tackling for months.  I prefer hard evidence to guesswork, but the alternative to this System 2 approach is to at least start with the most effective System 1 approach in our arsenal…a 5 second look at our equity curve.

Read The Janus Factor

Read Relative Momentum: A New Alternative to Relative Strength

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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