Double Top patterns have traders chasing trends

Cut your losses, let your winners run. The idea of buying what went up and selling shares that fell is older than an AOL dial-up customer. It is also the basis of an entire industry trying to make money out of price momentum.

Momentum can run only so far - and when it reverses, the process of cutting losses can hit prices hard.

Tuesday was notable for another bout of losses for bonds, as the rest of the world followed the sharp jump in US Treasury yields (and parallel fall in prices) overnight.

There is little in the way of fundamental explanations. Bond yields should rise if prospects for the economy are improving, or inflation expectations going up (or, frequently, both). In principle, such a change should be good for shares, but not this time.

The pattern is well-established: investors were fleeing crowded trades where too many had bought into the hype. Germany's Dax index led shares down in Europe, briefly falling more than 2 per cent - part of the reversal of its previous popularity as the biggest beneficiary of bets on a weaker euro. European carmakers went from being the best-performing sector in the eurozone this year to be the second-worst on Tuesday, after property.

Price momentum provides a useful way to frame this. Shareholders who owned stock purely because it had gone up found it was no longer rising, and bailed out.

The most momentum in the developed world was in US biotechs, which stormed ahead with barely a break for four years. More recently, biotechs outperformed as the dollar strengthened, and underperformed as it weakened (see chart). The biggest biotechs have a bit more reliance on overseas revenue than the S&P 500, so if anything, should suffer from a strong dollar. Except this is not about fundamentals, but momentum. When momentum traders pull in their horns, many momentum trades suffer together.

The same "double top" pattern has appeared across several sectors and commodities and mirrors the performance of trend-following hedge funds, known as CTAs, as Andrew Lapthorne at Societe Generale points out.

Traders will always chase trends. Investors can do little other than try to avoid the most crowded positions and hope the inevitable reverses do not up-end the market.

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation