The widespread endeavor to “identify” trends in market prices has given rise to a significant amount of literature. Elliott Wave Principles, Dow Theory, Business cycles, among many others, are common examples of attempts to better understand the nature of market prices trends.  

Unfortunately this literature often proves frustrating. In their attempt to discover new rules, many authors eventually lack precision and forget to apply basic research methodology. Results are indeed often presented without any reference neither to necessary hypotheses nor to confidence intervals. As a result, it is difficult for investors to find there firm guidance and to differentiate phonies from the real McCoy.  

This said, attempts to differentiate meaningful information from exogenous noise lie at the core of modern Statistics and Time Series Analysis. Time Series Analysis follows similar goals as the above mentioned approaches but in a manner which can be tested. Today more than ever, modern computing capacities can allow anybody to implement quite powerful tools and to independently tackle trend estimation issues. The primary aim of this 8th White Paper is to act as a comprehensive and simple handbook to the most widespread trend measurement techniques.  

Even equipped with refined measurement tools, investors have still to remain wary about their representation of trends. Trends are sometimes thought about as some hidden force pushing markets up or down. In this deterministic view, trends should persist. However, random walks also generate trends! Five reds drawn in a row from a non biased roulette wheel do not give any clue about the next drawn color. It is just a past trend with nothing to do with any underlying structure but a mere succession of independent events. And the bottom line is that none of those two hypotheses can be confirmed or dismissed with certainty.  

As a consequence, overfitting issues constitute one of the most serious pitfalls in applying trend filtering techniques in finance. Designing effective calibration procedures reveals to be as important as the theoretical knowledge of trend measurement theories. The practical use of trend extraction techniques for investment purposes constitutes the other topic addressed in this 8th White Paper.

Nicolas Gaussel
Global Head of Quantitative Asset Management
Lyxor Asset Management