Every book that addresses the subject of technical analysis devotes at least a few chapters to momentum trading and several related concepts, including trend following and relative-strength investing. But few, if any, of these concepts are understood by everyday investors, and this concerns me, so I thought I’d ask a close layperson—a longtime friend from high school—if she had any insight.


“What does trend following mean to you?” I asked.


It was a question I quickly regretted asking.


“Watching the runway shows,” she replied. “Parkas are coming back in fashion. They’re naturally edgy, but luxe fur trimming gives them a more glamorous, feminine look.”


Apparently, the New York fall fashion week verdict is in, and fur will be very popular this season, as will polka dots, tuxedos, geometric shapes, sheer fabrics and something called “peplum,” which I still can’t define, but I know was seen in several of the fall 2011 runway shoes, including Marc Jacobs, Proenza Schouler and Thakoon (She helped me spell those names).


As quickly as I wanted to escape that conversion, I had to admit, fashion trends and finance trends have more in common than one might imagine.


I look at it like this… A few years ago, a friend and his wife visited Japan, where Louis Vuitton is a popular brand. It seemed as if every woman they passed on the Tokyo streets was carrying a handbag patterned with that familiar LV monogram. My friend’s wife wasn’t impressed; she’s never been one to display labels, and had never expressed interested in a Louis Vuitton handbag. By the end of the trip, however, she owned two.


What happened there was not unlike what happens in finance: Trends are self-propagating. In fashion, it happens with clothing and accessories; in finance, it happens with stocks and other securities.


In finance, trend following is an investing strategy that seeks to take advantage of the moves that play out in various markets. Traders jump on what they perceive to be a trend (which is the tendency of a financial market price to move in a particular direction over time), ride the upswing, then exit and wait for another trend to appear.


Trend following is widely considered a type of momentum investing. Both momentum investing and trend following strategies are based on the idea that it’s best to buy when the price of a security is rising and sell when it’s falling. Traders usually have their own set of rules to determine when a trend is on and an exit strategy is to override their human tendency to hold losing positions too long.


Then there’s relative-strength investing, which is also often lumped into the category of momentum investing. According to Investopedia, relative strength is “a measure of price trend that indicates how a stock is performing relative to other stocks in its industry,” which means that relative-strength investing is simply trading based on relative price momentum.
Of course, as with fashion, if you ask a different person what all these concepts mean, you’ll get a different answer. If you don’t believe me, ask your wife or girlfriend what a “shaggy bob” is.


Regardless of the minute differences between momentum investing, including trend following and relative-strength investing, what’s important to note is that they’re all based on a similar, contrarian concept: a blatant defiance of the traditional investing strategies that has dominated asset management for many years. One is the buy-and-hold investing, which holds that the best way to make money in the markets is to select an investment and hold it indefinitely, because over time, the market will go up and the investment will appreciate. Another is the dividend discount model, which values stocks based on the net present value of their future dividends.


As a tactical allocation portfolio manager, I believe these traditional investing strategies have limitations. If you want to understand why, just look what happens to buy-and-hold investors in every bear market. Or, for a better illustration, consider an experiment conducted by Andrew Haldane, an economist at the Bank of England. He looked at a strategy that invested in U.S. equities based entirely on the direction of the stock market. Specifically, if the stock market rises in a period, at the end of that period the strategy buys stocks for the next period, and vice versa. The result? If you had invested $1 in 1880, you’d now have more than $50,000. Haldane then looked at a more traditional strategy. Essentially, it bought stocks only when they stock market appeared fundamentally overvalued based on the dividend discount model. If you had invested $1 in 1880, you’d now have 11 cents.


To me, momentum investing just makes sense, which is why at Niemann Capital Management, we use a relative-strength model that seeks to capture momentum based on overbought or oversold positions. That is, we re-balance the assets in our portfolios in order to take advantage of market pricing anomalies, be they in asset classes, geographic locations or sectors.


In other words, I, like my friend, believe in trend following. Which means I can fully expect to see a closet full of peplum by November.