Inertia - An application to investments as simple go to rule

 

“An object at rest will remain at rest unless acted upon by an external and unbalanced force. An object in motion will remain in motion unless acted upon by an external and unbalanced force” 

- The first law of Newtonian physics  

I don't want to get into the battle of whether finance is like physics, but Newton's first law of motion is a good framework for thinking about markets with respect to trends and reversals. 

A market in trend will stay in trend until there is a force to stop it. Similarly, a market at rest and rangebound will stay rangebound until there is a force that exerts the market to move it either up or down. Yes, as a starting framework, this is simple, but it serves as a good foundation. Reversals will occur when there is a reason or shock to the market. Markets will trend when there is a force pushing expectations and there is no change in that driver. 

The hard part is determining what are the forces that will drive prices. These can be macro and associated with central bank announcements or with economic data. For individual stocks, the force may be an earnings announcement. Of course, there are multiple forces that may exist outside of these announcement shocks. There is rebalancing, changing of sentiment based on volatility, reaction to news, and the general flow of funds across strategies and trading groups. Nevertheless, a key role of investing is identifying the forces that will drive markets to trend or reversal.

However, the foundation of trend-following and price-based models is that the forces driving price motion are hard to identify and even harder to properly link to prices. The reaction of economic agents and the impact of expectations make the link between force and price noisy. Hence, the focus for many is on extracting the signal from prices.