Jason's World

More than a month into my study in financial engineering, I have frequently ran into one of the most persistent mantras in trading, that “the trend is your friend”. Basically, stocks that perform well/poorly in the past will continue to perform well/poorly. There is a pretty strong academic case about it, as many studies have shown that trend-following consistently protects you from recessions and bear markets. This is true across all asset classes.

But it isn’t like this in all kinds of environments. If someone threw his or her money into the stock market on October 28, 1929, and on March 10, 2000, they will learn the hard way. Furthermore, even sophisticated trend following strategies tend to falter in choppy market environments. Probably because there really isn’t a clear trend that can be followed.

Judging by the former cases, one may conclude that the “trends” really aren’t what they’re made up to be. The people who threw money into the stock market on October 28, 1929, and on March 10, 2000 thought the trend would continue up. What happened?

We all know the old adage: “be fearful when others are greedy, and be greedy when others are fearful”. This shows that trends can be vulnerable to breaking once they reach a fever pitch. The principle is enshrined in technical indicators like the RSI and the Bollinger Bands. If indicators show that a stock is being overbought, certain contrarian investors might opt to sell short a stock. But even that doesn’t work all the time. Most who pointed to the seemingly overly high valuations of Nvidia have been proven wrong repeatedly. Of course, their fundamentals are uniquely strong, with breakneck growth being achieved quarter after quarter.

The real difficulty, I believe, is finding the warning signs that signify that a trend would break. Traditionally, in the case of Nvidia, some would point to the potential for new competitors and macro conditions to see if the gravy train will continue. But some of those warning signs have proven questionable as of late.

Take the rise in interest rates that broke the markets in 1929 and 2000. From 1928 to 1929, the Fed raised rates from 4% to 6% to curb speculation. From 1999 to 2000, the Fed raised rates five times, which many blamed for the burst in the dot com bubble.

The majority of analysts, extrapolating from past results, repeatedly warned of a market collapse as the Fed raised rates to combat inflation. But none of what the naysayers have said that were based on interest rates has come to fruition. The reason? “AI, AI, AI”. Despite the fact that we as a society have yet to really feel the benefits of AI on a massive scale in all aspects of our lives, it has nonetheless been hyped as the next big thing like the Internet in the 90s. Maybe that helped stave off the much-feared recession that many said was upon us-given widespread stock ownership in the U.S., bigger equity prices likely meant stronger consumer spending from the middle class. The trends have been upended-the paradigm has been fundamentally shifted since last spring.

Of course, no bull market lasts forever, and Nvidia is no longer growing at the rapid pace we have seen at the beginning at the year. But when it seemed like it was finally going to go down after the past earnings report, it bounced back. After Nvidia fell after its previous earnings report because it “hasn’t beaten earnings enough”, it is now close to all-time highs. This shows a shift towards a “when in doubt, AI is the route” environment.

The only silver lining to those who seek to find definitive trends now is that like other bull markets, this too shall pass. However given Nvidia’s unique strength, it would likely require a lot more negative factors piling on at the same time: if interest rates remain persistently high to the degree that the economy sees harm, if a competitor to Nvidia shows signs of gaining traction, then maybe the time will come when we can once again talk about a shift away from the “AI is king” market regime, because Nvidia has gotten so big that a significant drawdown would likely take the entire market with it, and perhaps even a hypothetical competitor can get hit. But given the prominence of high-frequency trading, the shift away from the current market regime will be sudden and won’t be immediately obvious. In the meantime, the only trends that matter will likely be the small intraday trends that individuals could try their luck at scalping a few bucks from.