Trends exists in most markets and trend-following is an effective strategy to exploit the behavior in prices. The evidence for this behavior has been strong and momentum by some finance professors has been called the fourth factor to explain return. However, many still wonder what causes trends. We have looked back through much of the finance literature and have developed our own stories for trends and have a growing list of reasons. All do not work at the same time and each may have a different time length and strength, but all are creditable reasons for why trends exist in market.
I break the rationale for trends into two major categories: economic and behavioral. The behavioral reasons are based on the actions of investors which will create under-reaction in prices. The economic reasons are based on the structure of the economy or markets and is unrelated to behavioral biases in investors.
The economic reasons:
1. There is wisdom in crowds - Evidence suggests that forecasts that are based on more than one point of view are valuable. Price action is another point of view and hence should be used with decision-making.
2. Following the herd - When an investor is at an information disadvantage or there is limited information, following the herd can be rational. The herd is the aggregated view embedded in market prices.
3. Under-reaction - Evidence suggests that markets under-react when there is a high degree of uncertainty. Market participants slow their response in the face of uncertainty.
4. Reaction to shocks - Markets face surprises but there may be frictions in markets which will lead to slow price reaction. This could be from spot activity, hedging, and transaction costs.
5. The limits to arbitrage - Arbitrage may be limited because there is a limit on capital, there are cash flows associated with arbitrage, there may be limits to knowledge and experience, and there may not be agreement on fair value.
6. Policy trends last for long periods - Monetary policy, for example, may be one directional for years which creates trends.
7. Economic trends last for long periods - Growth or pro-cyclical behavior can last for years. Recessions may be more short-lived but more extreme.
8. Markets follow cycles - This is especially true in commodities where supply cycles can last for quarters or years. These cycles can be independent of the business cycle.
9. Risk premia will follow economic cycles - Risk premia usually change slowly over time but follow trends that are counter-cyclical with business cycle.
10. Inelastic demand or supply - Price reaction will be larger over time because supply cannot be produced in short run or demand does not change for small changes in price.
11. Dispersion of beliefs - When there is greater dispersion of beliefs, there will be more trending. This is especially true of macro markets which have a hard time determining fair value.
12. Information uncertainty and drift - Prices will react slowly if there is poor information that is subject to errors and revisions.
13. Momentum and industrial growth - There has been a strong link between momentum in stocks and industrial or sector behavior. Similar markets move together and provide information on the sector.
14. Market state of over-confidence - There is more trending when there is a state of over-confidence on the overall economy. Macro behavior impacts micro expectations.
15. Price pressure effects - In the short run, there can be trends from hedging behavior and portfolio rebalancing.
16. Adaptive markets hypothesis - Andrew Lo developed this model based on evolution and competition within markets.
17. System neglect and regime change - Regime change or structural change is often not immediately noticed, so there can be trends around these periods.
18. Good and bad news reaction to surprise events - Tests have shown that markets under-react to good news and often over-react to bad news.
19. Behavior of small and noise traders - Markets may trend because of the behavior of marginal traders at different times.
The behavioral reasons:
1. the disposition effect - We hang onto our losers and sell winners within a portfolio. This will create trend behavior.
2. Conservatism - There is the slow update of information.
3. Representativeness - Investors often place too much on current weights
4. Analysts and herding behavior - Analysts will often herd with their forecasts being the same.
5. Investor distraction hypothesis - Distraction or neglect will often mean slow price reactions.
There are more reasons for why trends exist and it makes sense to follow trends. I have just mentioned some without even talking about technical analysis or any specific mechanism for finding trends. I am sure that others could add to this list.
The economic reasons:
1. There is wisdom in crowds - Evidence suggests that forecasts that are based on more than one point of view are valuable. Price action is another point of view and hence should be used with decision-making.
2. Following the herd - When an investor is at an information disadvantage or there is limited information, following the herd can be rational. The herd is the aggregated view embedded in market prices.
3. Under-reaction - Evidence suggests that markets under-react when there is a high degree of uncertainty. Market participants slow their response in the face of uncertainty.
4. Reaction to shocks - Markets face surprises but there may be frictions in markets which will lead to slow price reaction. This could be from spot activity, hedging, and transaction costs.
5. The limits to arbitrage - Arbitrage may be limited because there is a limit on capital, there are cash flows associated with arbitrage, there may be limits to knowledge and experience, and there may not be agreement on fair value.
6. Policy trends last for long periods - Monetary policy, for example, may be one directional for years which creates trends.
7. Economic trends last for long periods - Growth or pro-cyclical behavior can last for years. Recessions may be more short-lived but more extreme.
8. Markets follow cycles - This is especially true in commodities where supply cycles can last for quarters or years. These cycles can be independent of the business cycle.
9. Risk premia will follow economic cycles - Risk premia usually change slowly over time but follow trends that are counter-cyclical with business cycle.
10. Inelastic demand or supply - Price reaction will be larger over time because supply cannot be produced in short run or demand does not change for small changes in price.
11. Dispersion of beliefs - When there is greater dispersion of beliefs, there will be more trending. This is especially true of macro markets which have a hard time determining fair value.
12. Information uncertainty and drift - Prices will react slowly if there is poor information that is subject to errors and revisions.
13. Momentum and industrial growth - There has been a strong link between momentum in stocks and industrial or sector behavior. Similar markets move together and provide information on the sector.
14. Market state of over-confidence - There is more trending when there is a state of over-confidence on the overall economy. Macro behavior impacts micro expectations.
15. Price pressure effects - In the short run, there can be trends from hedging behavior and portfolio rebalancing.
16. Adaptive markets hypothesis - Andrew Lo developed this model based on evolution and competition within markets.
17. System neglect and regime change - Regime change or structural change is often not immediately noticed, so there can be trends around these periods.
18. Good and bad news reaction to surprise events - Tests have shown that markets under-react to good news and often over-react to bad news.
19. Behavior of small and noise traders - Markets may trend because of the behavior of marginal traders at different times.
The behavioral reasons:
1. the disposition effect - We hang onto our losers and sell winners within a portfolio. This will create trend behavior.
2. Conservatism - There is the slow update of information.
3. Representativeness - Investors often place too much on current weights
4. Analysts and herding behavior - Analysts will often herd with their forecasts being the same.
5. Investor distraction hypothesis - Distraction or neglect will often mean slow price reactions.
There are more reasons for why trends exist and it makes sense to follow trends. I have just mentioned some without even talking about technical analysis or any specific mechanism for finding trends. I am sure that others could add to this list.
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