Pod Insights Michael Covel's Trend Following Ep. 1376: Trend Following Motivation with Michael Covel on Trend Following Radio About this episode Please enjoy my monologue Trend Following Motivation with Michael Covel on Trend Following Radio. This episode may also include great outside guests from my archive.
---
I'm MICHAEL COVEL, the host of TREND FOLLOWING RADIO, and I'm proud to have delivered 10+ million podcast listens since 2012. Investments, economics, psychology, politics, decision-making, human behavior, entrepreneurship and trend following are all passionately explored and debated on my show.
To start? I'd like to give you a great piece of advice you can use in your life and trading journey… cut your losses! You will find much more about that philosophy here: https://www.trendfollowing.com/trend/
You can watch a free video here: https://www.trendfollowing.com/video/
Can't get enough of this episode? You can choose from my thousand plus episodes here: https://www.trendfollowing.com/podcast
My social media platforms:
Twitter: @covel https://twitter.com/covel
Facebook: @trendfollowing https://www.facebook.com/trendfollowing/
LinkedIn: @covel https://linkedin.com/in/covel/
Instagram: @mikecovel https://www.instagram.com/mikecovel/
Hope you enjoy my never-ending podcast conversation!
Transcript 0:00 Speaker 00 I'm feeling like a trend following interview today, but there is nobody I want to talk to right now. I sometimes feel like I've got the best insights over the last decade from the best trend following traders. And sometimes I don't feel like bugging them anymore. Now, I don't really feel like they feel like I'm bugging them. We both enjoy the conversation. But I think you know where I'm coming from. All that aside, let's get into a little trend following today. A little classic trend following conversation. One of those conversations that if you can't walk away today with a takeaway that helps you to make money, that maybe even helps you to make millions of dollars, something's wrong with you. Enjoy.
0:59 Speaker 00 My guest today is Nigal Kalagian. He is the guy that runs Quest Partners LLC. His second appearance on the show. Maybe this is the third, I'm not sure, but at least the second. Nigal runs a fund. He is a modeler. He's a trend following guy. He understands systems. He's got a great perspective on the big macro view, but he understands tail risk and he understands where we are today. Look, if you want steady returns, consistent returns, essentially fake returns, this is not a conversation for you. But if you have your eyes wide open and you want to learn something, Nigal brings it. Without any further delay, let's jump right into my conversation today with Nigal Kalagian.
1:54 Speaker 00 I want to share with you a story that happened to me. I was in an event. It was a typical event. Many of these things that you've seen, a lot of hedge fund managers in the room, a lot of bankers in the room, some pub-like setting, everyone's drinking wine or whatever. I started talking to this one hedge fund guy that I knew, this is about a month ago, and I said, so how are you guys doing? He goes, well, you know, relatively. And then, as he's saying the word relatively, before I even say anything, he's looking in my eyes and he's going, oh shit, we're not doing good.
2:30 Speaker 01 Yeah, I know, I know. That's how it goes, man.
2:33 Speaker 00 I'm gonna let you be the professor here for a second and explain this, these two words that sync together, absolute and relative. And I find, when I was thinking about this in advance of our call, I was thinking, relative is almost a way to say, "Don't look at me for performance, but damn it, I'm gonna take your fees. I'm gonna take your money and I'm gonna take your fees."
2:53 Speaker 01 Yeah, I would say, "Don't get me started on the hedge fund industry," because my perspective on the hedge fund industry, I mean, it's easily replicable. It's effectively a short put on the S and P. Nothing is going on. You've got 2%, 3% of alpha to the S and P. The S and P drops, you realize that you're actually correlated. You realize that you have much more risk than you ever thought. You realize that you can have much bigger drawdowns than you thought compared to the volatility of the hedge fund. So hedge fund is a vehicle where the correlation to the markets is effectively hidden by hedging the main risks, but you're also taking typically liquidity risk or other types of risks. The vol seems low, the correlation seems low, the drawdown seems low, but it's effectively you're getting paid for tail risk. Market drops and you realize that you're effectively much more correlated to the market, that your risk is high,
3:38 Speaker 01 and then you can have drawdowns, which are very large multiples of volatility.
3:42 Speaker 00 To break it down, though, at a real simple level for people, because you know there's gonna be sophisticated people listening, people that are kind of new, but this word relative, it's quite amazing because it really means "I'm beyond boringly average," but somehow or another, Wall Street has taken the word relative as some wonderful descriptive adjective about how great they are, and relative doesn't mean that.
4:07 Speaker 01 The hedge fund fees are very high compared to returns that it generates. The alpha is explainable by things that are effectively easy to replicate. Effectively, when the market is down, you say, "Relatively, we're doing better initially," but eventually, at some point, hedge funds actually start losing money faster and faster. Relative works when the S and P is down 10%, 20%. S and P drops more than you start seeing massive drawdowns and massive multiples of volatility drawdowns. On the way up, you say, "Hey, we're a hedge fund. The S and P is beating us." On the way down, you say, "Oh, on a relative basis, we're doing better than the market." You get paid 3% a year, 2.5% a year in fees.
4:44 Speaker 00 It's a nice game. This extends beyond just hedge funds. This is private equity and all kinds of venture capital, right?
4:51 Speaker 01 Correct, correct. I'm going to say if there's a holy grail today, the fact that risk is not linear. If you look at a hedge fund, you look at its correlation to the market. You look at a hedge fund, you look at its beta to the market. On the way up, hedge funds make less money than the market. And on the way down, they start to correlate more and more to the market. So effectively, the risk is not constant. And the less constant the risk is, the more option, short option like they are, the more alpha you generate. How can you do that? It's basically by trading in liquid instruments, or as I said, hedging the principal components of risk. So you're taking risks, which are the major better risk of the market is hedged. But the other ones are also correlated to the market. In fact, they're not active in everyday life. They're only active when the market is dropping.
5:34 Speaker 01 It's like a risk transfer mechanism and you get paid tons of money doing it, especially in an environment where the Fed is giving you that put, which is so powerful. You can write your own put on top because you're protected by the Fed. Doesn't make sense.
5:49 Speaker 00 Let me drive a little bit more here. You might have to be careful about how much you want to say, but for these hedge funds to get to this point where they're running these quote, their strategies are all the same. And they're not really even beating the market. And on the way down, they're not doing necessarily better than the market, but it takes two to tango. So there has to be investors that believe in these people. On the flip side, if they are, whether it's institutional pension, whatever, these people should know that a guy like you expresses the opinions that you express. However, it doesn't really affect their decisions that much because they keep plowing the money in. Can you explain to listeners out there why investors and who these investors might be?
6:32 Speaker 00 They go along with this routine, this typical hedge fund routine. Why do they go along with it? Who are they?
6:39 Speaker 01 Listen, when you're managing money for other people, typically you want to show that you're more stable than the market. Let's say, simplistically, you write puts on the S and P instead of going along the S and P. So effectively, for a while, you look more stable than the market, but then if the market drops a lot, which happens every five to 10 years, you have to write a nice letter to your investors saying, sorry, blah, blah, blah, this happened. But most of the time, it looks like you're much more stable than the market. If you're an institution, if you're basically managing money for others, which in today's world is 99.9% of assets out there are managed by institutions, they're not managed by the actual owner of the assets. I'm going to say there's a conflict of interest that the tail, which is highly, highly impactful to the end investor, is really not impactful to the institution that's managing the money.
7:25 Speaker 01 Effectively, if I look better than the market for 10 years, if it's more stable with a higher Sharpe ratio, then I can justify my fees. Now, if every 10 years, something bad happens and I have to justify it, typically it's worth the risk. Especially you look at these hedge funds and all these PMs that go around and effectively they're taking tail risk here and there. It blows up, they go to the next hedge fund and there's so much capital around, so much capital and people are looking for, when they say we're looking for something which has less market risk, these hedge funds look like they have less market risk. For a while, as the market is making new highs, the correlation to the S and P is typically low, it's like point two, point three, point four. Therefore, it looks like less risk, it looks like returns which are slightly lower than the market, but people feel like at least they're not taking market risk,
8:10 Speaker 01 which is very, very false and shows that the market risk is hidden. Really, it looks like it's a separate investment, it doesn't look like very market correlated. And second, the misalignment of interests where the end investor really cares where he's going to end up in 20 years or 10 years. The intermediary doesn't really care that much. The intermediary is interested in keeping the assets for a long time and to earn his fees. It's a game which is self-perpetuating.
8:34 Speaker 00 As you make that point, I'm thinking also too, if these time horizons are 10 years plus perhaps, then you have career turnover, career change in staffing, and then it just becomes the next guy's problem. And so these huge piles of capital could have, I don't know how long a manager or the decision makers hang around, but that things just keep moving on. And then the end investor, I guess they're just trusting the system, so to speak. The firemen and the teachers, et cetera, they're just trusting that everything is going to go along. And then wham bam, thank you, ma'am. As you point out, it's these steady returns. I always say that if I see a track record that shows me that it's making 1% a month, every month for decades, I either have Madoff or Long Term Capital Management.
9:17 Speaker 01 Absolutely. Actually, for us, we measure risk not through volatility. We're saying today volatility does not measure risk. Don't even bother looking at volatility because that's not what you're getting paid for. That's why you have such variation in the sharp ratios of hedge funds. The real thing that you're getting paid for is tail risk. Effectively, you can say, I can measure the tail risk of a hedge fund to see how much sharp ratio or alpha return I should expect. Or what we say actually is don't even bother looking at the convexity, just look at the sharp ratio. Effectively, sharp ratio and convexity are 80% correlated. All we're saying, the steadier the return, the bigger the tail risk with 80% correlation.
9:55 Speaker 00 I'm going to let you get into convexity in a second because it's a buzz term, not an academic term a little bit. But once people understand it, it's a quite important concept. But first, I want to take you back in time a little bit because if I look at your career, you look like a persistent guy. You keep grinding. Give my audience an understanding of where you started and where you are. Because you definitely didn't start with the quote silver spoon. You definitely have grinded it out to get to something that's quite successful.
10:29 Speaker 01 Definitely. I mean, I didn't have this big finance pedigree. I never worked for a big firm. I mean, I worked for a small hedge fund for a couple of years. For me, we started in 1999 with 3 million under management, literally. We went through a cycle where we grew to about 600 million. And we started in 1999, the first pick in assets was about 600 million in 2008, 2009. Effectively, ninety percent of our assets came from one large CTA, the fund of one large CTA. I won't mention the name, but they're UK-based. In 2010, they redeemed.
11:00 Speaker 00 You didn't necessarily like that feeling. That was the world that you were in. You accepted it, but you always knew it was not a perfect situation.
11:08 Speaker 01 They're highly sophisticated and they understood. We did very, very well. Not only our returns, but our alphas, our relationship to what's going on to volatility and what's going on in the S and P and what's going on in some very specific things in the market. Because they understood us so well, we had, I would say, a full sense of security. We never expected that this firm would actually get hit in 2008. They were, at least their fund of funds, would get hit to such a large extent. They had investments with us, but they also had investment in credit and other illiquid things. Effectively, they needed a lot of cash and very quickly, and they had to redeem us to meet their cash needs. We were almost like servicing one highly sophisticated client, but we didn't have to build a business. It was great because we got to focus on research.
11:50 Speaker 01 It wasn't so great because we didn't really build an asset raising infrastructure. We didn't have demanding clients who were like, hey, where is this? Where is your CFO? Where is your COO? So the business was run very, very lean. It was basically great research years and to interact with that type of client, you also learn a lot about the industry and all kind of things. Now, when they redeemed in 2010, 2011, our assets dropped back to like forty million. Not only did we lose ninety percent of our assets. Personally, I was invested in the program. Two thousand nine onwards, our returns were weaker. Very, very difficult period and we had no money. So I had to basically fund the business and put cash back into the business to keep it floating.
12:32 Speaker 01 Philosophically for me, I'm not looking short term at my results. I'm looking for the long term stability. If I was looking to have months to months high sharp ratio, I would have said, you know what? I'm never going to make it, but my expectations are more that at the end I want to be the guy closer to the top. What happens in between, I really don't care that much. As long as my expectations are reasonable, I can have more stability long term by allowing for short term instability or what looks like short term instability. So always the business, I knew that in the long term market cycle, when the volatility actually kicks in, I'll be on top. I'll make new highs and all kind of things. It was this very long term perspective. For me, the results, I do what I can do and I try to add value every day in every aspect of the business and all that.
13:17 Speaker 01 If every day I'm doing the right thing, I believe that long term I would add the most value. And that's what I did. So I didn't really focus on the fact that we lost ninety percent of assets and the business was bleeding money. And all that, I just kept going. If I was very attached to the results, I would have easily given up. Every day I went to work with a very open mind. I always told myself this business started at zero. We had no assets when we started and one day it's gonna go back to zero. Maybe today, by the afternoon, I'll decide to shut down the business. It was too difficult to think of next week or next month, et cetera. I said, let's take it day by day. And then day by day, I was able to say, you know, okay, today went well. We're still in business, great. Tomorrow, we're still in business, but I kept an open mind. I didn't have this rigid mental attitude that
14:03 Speaker 01 things have to be great all the time and here things have to go my way and it's look perfect. That allowed me the flexibility to go through very, very tough periods where most of my peers would have given up. Or they would have modified the models to be adapted to a market regime, which is highly unstable. Which is the S and P going up and the vol being low and bottom picking and risk parity and all the things that were really working well that we've written about in our research. Having a long term perspective is very, very important.
14:31 Speaker 00 Once you get to that perspective, though, that entrepreneurial perspective, which is what you just described. Fund management, trading aside, that entrepreneurial perspective. It's so deep in your bones and it's deep in my bones, a different type of business, but you can't go back. You can never be an employee again, I don't think. You're done. You work for yourself. You enjoy that feeling. You like the struggle. You can't escape that. That is you. And that is probably why, I'm guessing, clients, people you work with, they want to be with you because they know you can't escape that. You're driven to that.
15:09 Speaker 01 Really being accountable a hundred percent for my actions and getting direct feedback from the market, I want that voltage. If I do something which is great, I want the market to at some point reward me for it. And if I'm not doing well, I want the market to tell me as well. For me, it's the fun and the learning and the growth, the evolution of what we do, the levels of complexity that we keep adding to the business as we grow from three million in 1999 to the close to three billion. The fun part is the learning. That's what I enjoy and this constant process of evolution. The entrepreneurial spirit, in my opinion, I'm here to serve, whether I'm serving a corporation or I'm serving large pensions, I'm here to serve. I feel more comfortable in an entrepreneurial environment
15:53 Speaker 01 where I can set the tone, I can set the culture. I'm more likely to succeed when the culture is something I set than in a culture with somebody else set. Also, I'm more likely to set the strategic goals correctly in line with my beliefs. So that when, if I'm trading something and I don't believe in the high level strategic direction of the business, I'm going to have a much harder time being fully, fully dedicated and fully creative. My father, when I was a kid, used to tell me, you're better off selling newspapers than working for a big company. So the first chance you get, start your own company. It doesn't matter what you do, but at least your feedback loop is much faster, is much more exact. I went with that philosophy. It seems to have worked. It's possible that in some environments,
16:38 Speaker 01 entrepreneurship will be much more difficult and large corporations will rule the world, et cetera, and be very hard to compete. But luckily, in the business that we're in, I was able to stay competitive with the large firms and today we're a decent business.
16:52 Speaker 00 Let me shift you into something topical and see if you have a view on this. And after I ask this question, we're going to move into some models and some convexity. But there's been a lot of interesting news in the last month, particularly a young investor down in the Bahamas. You are in a world where you are highly regulated. You understand what the rules are. You understand if you break those rules, okay, maybe somebody escapes scrutiny for a long time like Madoff. But basically, there's a certain amount of transparency. You play by those rules. How do you feel when you watch something unfolding with SBF? How do you perceive that and what's unfolding? It seems rather unusual, to say the least.
17:38 Speaker 01 It's normal considering the sentiment in the market. There's so much cash around, there's so much money floating around. What you see happening in crypto and all the money that was made and all the money that was lost, all the guys that were sitting in cafes all day, drinking coffee on their laptops and making millions and all that. That's one aspect of a massive money printing market regime that we're in. It's not unexpected when you have bubbles of the size that we have, when there's so much paper floating around compared to the real economy. You're gonna have asset bubbles right and left. The fact that this one grew so quickly that it was so unregulated. The regulators are very, very slow machines. They respond to problems, they have a hard time predicting them.
18:24 Speaker 01 The industry itself obviously would rather not be regulated. So the industry is gonna try to defend itself. In particular, something like crypto, which is being sold as a way out of the system, as a way to be independent from the fiat money system. I'm not surprised that it would happen there.
18:40 Speaker 00 It's the bigger issue of too much money. So it's not surprising that too much money finds its way to some particular individuals on some particular perhaps scam, that that's not surprising.
18:52 Speaker 01 Yeah, people are here marketing new cryptocurrencies. And that's the opportunity that's available when you have this much money around. People don't need to be as diligent in terms of where they invest. If the opportunity is to make 500% a year, 100% a year, et cetera, which massive returns like crypto had. You say, hey, it's worth the risk. Everybody said it's worth the risk. People maybe didn't think as much, maybe they gave 1%, 2%, 3% of their assets, hopefully not more. Obviously, the younger you are, the bigger percentage of your assets typically would have invested in crypto. People didn't take it very seriously. It's like, what's the big deal if I lose 3% of my assets? 3% of your assets, everybody does that. Next thing you know, something which had normal market cap is 10 billion market cap. It's expected.
19:33 Speaker 00 It's expected but unfortunate.
19:35 Speaker 01 What I'm saying is it should be a lesson for what could come at a bigger scale. That's what's unfortunate. People are not seeing that when you have financial markets beat two times the size of GDP, you're at all time highs and this what's called the Buffett ratio. Effectively, the real economy is not growing in parallel with paper markets. And that's a very, very dangerous situation. It's an economy which is so over leveraged financially that even small corrections in the paper economy in finance and the market cap of equities would have very big impact on GDP. When the size of the market cap of equities is two times GDP, the market goes down 1%. That has the impact of reducing money supply by 2%.
20:17 Speaker 01 It's massive. Today, we're in a place the Fed by encouraging this paper growth has effectively said, don't worry about the real economy growing as much. We're more interested in maintaining a financial system which is stable, no matter what the underlying fundamentals of the true economy are. That's what we're being told. That's what's happened for two decades now.
20:40 Speaker 00 Let me shift you into the real operative question for me. I'm sure I've asked this of you before. When is the moment where you had your aha moment for the first time? Where you realized, well, you were just giving some opinions about the Fed and money supply, et cetera, and bubbles. But your day to day isn't necessarily that analysis of that. Your day to day are models and many of those models are based on price. When did you have your first aha moment of, hold on, I can try to analyze all these macro events. I can try to analyze all these fundamentals. But if I look at price, I've got something. When did that first happen for you?
21:22 Speaker 01 When I was 23 years old, at the time, I used to read a newspaper called Investors Business Daily that made pretty wild claims about their system of ranking stocks and all that. I had a PC and I started testing their claims. Most of their indicators were used to time the stock market overall. I took the indicators that they provided and tested them one by one and saw that they effectively had no value on a return to drawdown perspective on a risk-adjusted basis. Eventually, I started reading books on trading. Eventually, I read a small, tiny little book about volatility breakout, not Toby Crable's book, but someone else's who had worked for him. I became acquainted with what's called volatility breakout. From there, I saw an incredible opportunity and I understood
22:08 Speaker 01 that investors are measuring risk in a very the risk monitoring mechanism that most investors are using is inappropriate to measure the true risk in the market. You're only measuring one very, very limited aspect of risk. Standard deviation of returns, or what people call volatility or value at risk, effectively is measuring one type of market movement. You can have the market go up 500% and standard deviation can be zero. So if a market goes up 10% a day, standard deviation of return is actually zero. There's no variation around the mean return. The fact that it's going up 10% a day would have no impact on volatility. Effectively, risk equals zero. Take massive risk and pile up into the market.
22:50 Speaker 01 How is that possible? Something which is up 10% a day is highly, highly risk and it's not being captured. Tail risk is not being captured by the
22:58 Speaker 00 Are you telling me that I should not be worshiping the sharp ratio?
23:03 Speaker 01 In this environment, sharp ratio works for the beginning of the market cycle, but with a full cycle taken into account, it typically doesn't. Sharp ratio is a predictor of tail risk. Sharp ratio effectively predicts how big your drawdown is going to be as a multiple of volatility. The higher the sharp ratio, the bigger your pickel trough loss as a multiple of volatility. Effectively, high sharp equals high tail risk. From there, when I said, okay, this is a massive opportunity that people are being lazy in the way they're monitoring risk and the way they're risk budgeting. And there's an opportunity to, in a way, arbitrage that, to trade the breakouts when the volatility is low. There's places where you can actually go almost like long an option in a way which is much cheaper than actually being long the option itself.
23:48 Speaker 01 I said, hey, this is great. I'm gonna do this. In particular, for me, it actually matched my longer term perspective. So I was talking about my macro perspective. My macro perspective is not important. My historical experience in life, growing up in the third world, seeing hyperinflation, seeing paper money effectively losing like 10% of its value. That's very, very impactful for me to see what the possibilities are for the long term market cycle. And that effectively guides research. That's why when we're doing research, we're effectively risk normalizing based on tail risk, not on volatility. What I'm saying is my macro perspectives, although we're not trying to predict the market is gonna go up, it's gonna go down.
24:30 Speaker 01 It tells me that taking into account the very long term cycle and what's gonna happen in 50 years, not only in the next 10 years. Be ready to handle very, very large tail events. That's very, very relevant today.
24:42 Speaker 00 I'm looking here, I've got something I just jotted down. Large returns, small losses. Small returns, large losses. The simple expressions, large returns, small losses. Small returns, large losses. We could teach an entire four year college class on that. All the tangential aspects to that. Because the notion of large returns, small losses. This is not something that people want. They want consistency. Whether that's at the institutional level, the individual retail level. They somehow or another, and maybe it's just human nature, have imagined that consistency is the goal. Somehow or another, we can look around the world and can realize that nothing is consistent.
25:26 Speaker 00 But the markets, which are simply made up of more people, those should be consistent. And when I want the magic money machine to give me money, I want it consistent. It's really amazing that we can imagine this consistency when there's no evidence for it.
25:39 Speaker 01 We're being sold something very different. We're being sold that this is an economy where consumers, and you can have anything you want at any point. You can have ketchup delivered to your door within 10 minutes by going online. Everything is immediate reward. Anything you want, you can have. It's the same in markets. If you desire to have consistency, you can have it. The reality is different. Reality is this is a real economy and to have consistency and to have growth, you need to be productive and value add. That's not what we're teaching people. Our whole economy is falling behind the rest of the world. And we're trying to play games with the paper surrounding it in order to make it grow. Eventually, the real economy is the ultimate truth. It's unfortunately, in my opinion, in real terms, shrinking.
26:24 Speaker 00 You've brought it up a couple of times with the printing and the bubbles and whatnot. This is not a question to try to get you to make a prediction. That's not my point. But if you were to explain to people in a little more detail where we are in the quote market cycle in terms of looking at the imbalances. And you've mentioned tail risk multiple times and that being ready for tail risk. It does seem like a moment in time. Let's assume someone has no market knowledge. They look around the world at various events. US dollar going up, Japanese yen going down, trouble in China, trouble in Europe, energy prices. It seems like intuitively that people would realize these are really extended
27:08 Speaker 00 unusual moves happening in multiple countries. Yes, things are related, but they kind of look unrelated. Then at the same time, you've got a media machine telling everybody, it's okay. We're close to all time equity highs. It's an amazing time period.
27:24 Speaker 01 Well, if you're here and you're in a business of printing money, which I would say that's the most major business that we're in today as a country. I mean, we print this money and we distribute it all over the world. The story that's being told is part of the marketing machine. Just to give you a sense of equity market cap to GDP, the Buffett ratio. On average, it's around point seven. Recently, it was around two point two. We're about three times higher than the peak historical average today. It's back down a little bit there on maybe one point seven. That's how much paper there is relative to the economy. The way inflation actually hits is you can control paper markets by printing and all that. You cannot control real commodities, right? You cannot print real commodities.
28:09 Speaker 01 Unfortunately, you have to compete with other countries in terms of what you pay for them. Countries that are more productive or have a truly growing economy are going to want to pay more for those real commodities. We're in a place today in the world where we depend on the rest of the world for a lot of things that are in the physical world. There's so much money around, people are willing to pay anything to get those things.
28:31 Speaker 00 You mentioned earlier you growing up in the third world.
28:34 Speaker 01 Uh huh.
28:36 Speaker 00 Where did you grow up?
28:37 Speaker 01 I was born in Beirut, Lebanon, actually, just before the war.
28:41 Speaker 00 The reason I bring that up is I guess some would say that places like Saigon is still the third world. It's moving up the ladder quickly, but I think what's interesting is when you talk about, I don't know if this would apply to Beirut today, but around the world, a lot of people, whether it's if they don't trust their home currency, it's not unusual for people to want to have, whether it's physical gold or Ben Franklin's in the wall somewhere. There's a real trust of the American dollar. They see that in terms of purchasing power and their own home currencies being debased. I always think it'd be interesting, though, that maybe some of the people that are in the quote third world that have not had a chance to visit America, that if the rest
29:20 Speaker 00 of the world had a chance to fully see the picture of the inside of America, how people are living and whatnot, if the rest of the world would believe in the dollar so much. What do you think?
29:35 Speaker 01 For now, the dollar is a better currency than the other currencies around the world because it has the benefit of having.
29:43 Speaker 00 It's the tallest midget.
29:44 Speaker 01 It also has the US Army to defend it.
29:46 Speaker 00 Sure, sure.
29:47 Speaker 01 If a country wants payment for its oil and other currencies gets invaded and an next regime is put in place, not that the dollar doesn't have weaknesses, but I would say it's still a strong currency, but not because of the economy or monetary policy, but more because of the strength of the US Army and the impact that we have all over the world.
30:07 Speaker 00 Fair point, fair point.
30:08 Speaker 01 That's the major difference. We can print faster than anyone else and still effectively not devalue where we can control the devaluation.
30:16 Speaker 00 Let me bring it back to models. Do you try to, at this point in your life, and look, there's some primary models that you guys trade, but when it comes to looking at strategies and analysis.
30:29 Speaker 00 You're attempting to model everything. You want to model it. You want to create an automated system, so to speak. That's your edge. That's what you figured out.
30:39 Speaker 01 Yeah. Markets are about supply and demand. We all read the same news. Then we all have biases which are very, very difficult to perceive. Requires a lot of self-awareness to be aware of your biases relative to the common mindset of the market. Models are a way to protect you from thinking like the crowd. It's a way to find these very, very little quirks in the way that people think. Their overconfidence relative to historical norms and to take advantage of them. It's very difficult. The amount of data that you have to analyze, it's impossible for the mind to do this. The mind can handle these new pieces of information here and there better than a system.
31:21 Speaker 01 But the moment you can automate something and think of it systematically across markets, across time, you're going to have a much deeper perspective, a much richer perspective on factors that are driving the returns in markets. So no question, I mean, as an individual investor, I'm a retail guy. I don't know how to invest personally. The models are driving returns 100%. The models look at nothing but price. Nothing but price. There's zero fundamental information. We're not participating in the game of digesting fundamental information and setting price accordingly. We're purely reading market price, saying, what are the inefficiencies that we can see through price?
32:02 Speaker 01 Through price, of course, we calculate all these different aspects of volatility and we try to arbitrage those. What is the volatility of a market when it's making new highs and new lows versus when it's in the middle of the daily bar? Really quirky little things that help you predict extensions of the moves and things that other people don't typically see. Just because they have other things to worry about or their edge is elsewhere. We have this very particular edge. Over 20 years, it's evolved incredibly. It went from systems being optimized on a per-market basis to more complex systems, different ways of measuring volatility. Today. We're one step beyond all this. We have all these factors that we run, all these alphas.
32:44 Speaker 01 And we're actually predicting not what has worked, but what is going to work in the future based on what the market is doing today. We're predicting the market regime shifts from this current market regime. And what's working today, what is going to work next? What market is going to attract too much capital? A system that has a sharp ratio of one is going to become minus one. We're predicting asset flows and how market characteristics are going to change across four different dimensions, effectively trading the breakouts or trading momentum. You can choose to trade one of four asset classes. That's the first dimension, equities, fixed income effects and commodities. You can trade, decide to trade short term or long term. That's another dimension.
33:28 Speaker 01 You can decide to be trading in certain markets versus others within an asset class. You might want to be long US equities and short European equities. That's the third dimension. And finally, the fourth dimension is there are many different ways to trade volatility or momentum. You can trade channel breakouts, you can trade moving averages, you can trade price momentum, price today relative to price a year ago. Or you can trade volatility breakout. So if the market moves a certain multiple of volatility, you go long and if it moves down a certain multiple of it, you go short. So these four dimensions of momentum. We're playing an arbitrage in these four dimensions, saying where can we get the cheapest possible trends? All based on price. It's all derivative of price on top of derivative of price.
34:12 Speaker 01 So we're finding all these quirks that are telling us trend is cheap here and it's overdone there. It's almost like a statistical R strategy within the momentum space. It's learning how to learn. It's predicting how people are going to react to the market based on the historical returns. That's the real edge. If you hire a hundred quants, they'll show you models with sharp ratio of one, minimum. You give them capital, you'll see that maybe five out of a hundred make money. It's not a fact that they over optimize. It's a fact that what is working today is going to attract capital. Markets are much less liquid than most people assume. And there's going to be a market regime shifts. Markets are much more responsive to what people are doing. The market regimes shift so aggressively.
34:56 Speaker 01 You go from low vol to high vol. You go from a certain type of noise to a different type of noise. And we're trying to predict these market regime shifts. It's a question of second order thinking. It's not a question of optimizing or being a good researcher. It's predicting the shift in thinking.
35:13 Speaker 00 What's interesting is you talk about that shift in thinking. I'll share a quick story. Someone emailed me the other day and they were expressing thanks for, I don't know. Maybe they read one of my books or something and they were introduced to the concept of trend following. I guess they somewhat got unlucky that they started this year. And maybe they made an allocation to somebody and they're up pretty big coming into, I guess, the last month. The way the individual said it to me was, thanks. This has been really great. It's been a great year, except for the most recent drawdown. It was almost like they understood, or they said they understood this idea of trend following. They'd had a good year, then was lamenting some recent drawdown. Like somehow or another, they had come to think that trend following only goes up,
35:57 Speaker 00 that you only make money going up in trend following and there's no down periods. It was the same thing that they might've applied to buy and hold the S and P. And now they were applying the same thinking to trend following, even though they were expressing they understood what trend following was all about. And you're not going to have this consistency. Humans can't help themselves. They want to reach for that consistency again and again and again.
36:18 Speaker 01 Yeah, there are ways to numb pain. The more you numb your pain, the more out of touch with reality you are. People can keep their minds busy watching TV, this, that. But at some point, you gotta sit and look at what's really going on in the world. It's the same with markets. I would say the more difficult and the less justifiable a position is, based on the information available, the more alpha that position will give you. If you look into the market and you find all these reasons, all these justifications for a position, for a system, for an allocation. The less likely you are to produce alpha, the things which are fed in our brains and the way our brains are wired to think, you have to design models that do exactly the opposite.
37:01 Speaker 01 There's first order thinking, which is like retail, second order thinking, you can say is almost institutional, then you have to go to the another level beyond that to think how to be one level ahead of the institutions and their ways of allocating money.
37:16 Speaker 00 You made a point earlier about we're all looking at the same information I was thinking about. I've enjoyed watching Elon Musk's recent tweets where he's explaining how he's trying to build his new Twitter business. It's quite fascinating to see he's giving a little transparency, probably not a lot, but a little. So it's fun. I think what's interesting when any of us look at any particular individual and we read their posts or their tweets or whatnot, we have this feeling of, ah, we're getting some information, some inside information. We know something. Hold on. Elon's got, I don't know, 100 million followers. There's nothing inside about it at all. It's just, it's, everyone's getting the same thing at the same time. And I think that's the point that you're making is across this conversation
38:00 Speaker 00 is if you want to find edge, if you're looking at the same fit that everyone else is looking at, you're not going to find edge. You're just going to be entertained, I guess.
38:09 Speaker 01 In markets, you have to be differentiated. It's not a question of you can be super smart, but if everybody is as smart as the same reasoning, you're going to end up losing money very, very consistently. It's a question of understanding how differentiated you are, not a question of understanding being smart. Intelligence goes only so far. You have to find ways of systematizing your differentiation. That's really key. It's not a question of higher intelligence.
38:34 Speaker 00 You hinted at some things early on, but do you have any particular influences when it comes to individuals that have influenced your career? Or was it mostly a self-taught process you went down?
38:48 Speaker 01 I have over the years, a lot of different people were very influential. In the early days, Toby Krable, some of his work on volatility, volatility breakout, Harry Kaufman and those books. Later on, it was more like the big hedge fund researchers and all their work was influential. Today, we're in a place where I would say the limitations that I'm dealing with are more on the management side of the business and how to create a culture and all that, the likes of Ray Dalio and then. In the spiritual realm, having the right mindset, the right philosophy, the right expectations, not to have high expectation, allowing yourself to feel pain. A lot of these things are, the people who teach these type of philosophies are the ones that I follow.
39:32 Speaker 01 There's people who are extremely advanced in all fields of life. And today, on the internet, you have access to their very deep thoughts. They might not be popular, but you have really incredible, incredible, incredible access to them. If you're not sitting passively and watching what's being offered to you. I have many, many, many teachers. In my office here at home, as I said, I see piles of books on top of bookshelves, full of books, and piles of books on the floor, on my desk, everywhere. And for me, I want as many different perspectives as possible. Some of them are great, but it's still useful to know what other people are thinking. My understanding of the world is, ideally, I can think like an expert in every field by reading their books and understanding their thinking. I can adopt a way of thinking, I'm not a patch to the ways, I think.
40:17 Speaker 01 And that's really key. Today, the world is evolving so fast, you have to be able to give up massive amounts of assumptions that you've made and things you've learned in the past and use new ones because the world has changed. For me, that's, the learning mindset is really key.
40:34 Speaker 00 I'll share with you really quick. I've spent basically the last decade in a Buddhist country. I'm not saying I'm an active practitioner or studying by any stretch of the imagination, but I'm around a lot of people that are. By the process of osmosis, I find it interesting to look back at myself to realize how much of a shift has happened in me. An unexpected shift. I didn't fight the shift, but an unexpected shift. And I appreciate, I think you already understand where I'm going. But for a lot of people that have not had those kinds of experiences, it is quite nice to find yourself in that kind of environment. It really does change you.
41:12 Speaker 01 Absolutely. There's a certain humility that comes with Buddhism. Which is tremendous. For me, the more I got educated in Western schools and Ivy League schools and that type of thing, the more arrogant I became, the more confident I became of my thoughts, the less I could learn. Eventually, I became so rigid that I couldn't function, I couldn't add value. At some point, by chance, I landed in this Zen retreat in upstate New York. Basically, the practices from a linear perspective, so difficult, so painful physically, it's almost I had to give up everything that I knew and start again. That's, I would say, the first experience of, you know what, everything I know is not relevant. That's kind of like something
41:54 Speaker 01 I've put in there and I can choose a completely different mindset. I became detached from my thoughts. In Zen, they say beginner's mind, can you really see the world like it is without preconceived notions? I would say Buddhism is a great philosophy, rather than a religion, a great philosophy to keep this flexibility and humility in front of reality so that you accept things like they are, rather than impose your thoughts on the world.
42:17 Speaker 00 It works well if you become a system trader or a modeler. They dovetail well together, don't they?
42:23 Speaker 01 Yeah, you have to accept that you have to go through so much pain, basically surrender control to the parts of you and the parts of the system that are actually the ones that are adding value. And you have to quiet the rest of your mind so that it does not interfere with the discipline that is required to follow the systems. So yes, for me, it's a must. I've been practicing meditation since 1992, almost daily since 1996. It's a critical part of what I have to do to be ready to go to work and to think like a systems trader.
42:54 Speaker 00 Nigal, great stuff. Again, we have to have more regular conversations. This podcast has varied so much over the years and many times it expanded beyond trading. This year especially, I felt myself wanting to reach back and talk to so many of the smart people that came on, perhaps early on, and I drifted to all these conversations beyond trading. But I guess this has been one of those great years where it's like, I gotta get all those systems and trends guys and model guys on. It's such a great year to have these conversations. Hey, Nigal, where can we send people? At questpartnersllc.com? Is that the main place?
43:27 Speaker 01 Yep, that's it.
43:29 Speaker 00 Anything else you want to say? I bounce you around to a lot of different things.
43:34 Speaker 01 Michael, I really enjoyed the conversation. I think that we're living in incredible period in the US. The level of prosperity despite some underlying weaknesses, but we're still, it's an incredible period to be alive, this incredible opportunity. It's an amazing time to be active in this business. I hope your listeners are persistent and are doing what they want to do. There's really incredible opportunity out there. I'm just, I guess, in a way excited for everyone. I hope people pursue what's in their heart and be great at it and be successful at it. There's just a lot of resources and possibilities today.
44:06 Speaker 00 Great stuff. Let's continue the conversation. Have a great evening. We will talk against her.
44:13 Speaker 01 Thank you, Michael. Thank you so much.
44:20 Speaker 02 I see a time when those awake will understand how to make money in up, down, and surprise markets. Whether a new trader or experienced, college student or financial advisor, protecting against a crash or just trying to make a lot of money, trend following offers everyone an answer in uncertain times. To get started immediately, send me an email, [email protected] . I will send you the right trend following steps to take, along with my free video. But if you want to buy and hold, trust the government and trust Wall Street, this is absolutely not for you.
Previous Ep. 1375: Size It Right with Michael Covel on Trend Following Radio Next Ep. 1377: Men Can't Make Babies and the Zero Sum Game with Michael Covel on Trend Following Radio Page updated November 6, 2026 · transcript and summary are machine-generated
