Business

The Case For Trend Following

“We tend to hang onto our views too long simply because we spent time and effort coming up with those views in the first place.
This leads to confirmation bias and an anchoring to strongly held beliefs even if the evidence fails to support them anymore.”

– James Montier, The Little Book of Behavioral Investing

“The key to money management.  It’s making a lot of money when you’re right and minimizing it when you’re wrong.”

– Stan Druckenmiller

One of the charts I like to keep an eye on looks at inflation and its impact on stock prices.  In rising inflationary periods, stocks tend to struggle.  When inflation is falling, stocks tend to perform well.

Trend following can help signal what cycle we are in.  When I saw the following chart earlier this month I took note.  I shared it with my team and share it with you today.  In short, it shows that rising inflation is not good for stocks.  A “sell” signal for stocks.  Here is how to read it:

  • The bottom section plots the consumer price index “CPI” (red price trend line) and also the average price of that line over the last six months.  The idea is to see if the current price is above the smoothed six-month average trend line or below.  Up-trend or down-trend.
  • The CPI is calculated by the Bureau of Labor Statistics and comes out monthly.  The index includes a variety of goods, such as food, clothing, automobiles, homes, household furnishings, household supplies, fuel, drugs, recreational goods, doctor fees, lawyer fees, rent, repair costs, transportation fares, public utility rates, federal, state and local taxes.
  • By smoothing the average price we can see what the general trend in consumer price inflation looks like. Moving higher?  Moving lower?
  • When the CPI rises above its six-month average price by more than 0.6%, a sell signal is triggered for the stock market. The indication is a period of rising inflation.  The theory and reality is that when the costs of things rise, corporate profits are less, earnings are less and stock prices are negatively impacted.  Plus your money and mine just doesn’t go as far when the price of things we must buy goes up.
  • The reverse is true when inflation declines. When the CPI declines below its six-month average, a “buy” signal for stocks is generated.
  • Up arrows mark the “buy” signals, down arrows mark the “sell” signals.
  • The most recent signal occurred on 12-31-2016: a sell signal, which suggests rising inflation risk and a more challenging period for stocks.

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Source: Ned Davis Research

Take a look at the upper left-hand section of the chart.  Following this process increased annual gains by 50% over a buy-and-hold approach.  This is a good example of a simple “trend following” approach to investment management.

It is not perfect and there are times it outperforms and times when it underperforms, but it did, over the entire period, beat buy-and-hold by more than 50%.  Note too it did a good job of avoiding the 1987 crash, the challenges in 1992 and most of the 2007/08 financial crisis.  It did not help in 2000-2002.  But 50% improvement over buy-and-hold over many years is pretty good.  Avoiding large drawdowns is key.

Looking just at inflation, next is the NDR Inflation Timing Model chart.  I’ll continue to share it with you from time to time.  The model measures the year-over-year rate of change in inflation.  The model consists of 22 indicators that primarily measure the various rates of change of such indicators as commodity prices, consumer prices, producer prices and industrial production. Inflation is on the rise.

Here is how you read the chart:

  • The model totals all the indicator readings and provides a score ranging from +22 (strong inflationary pressures) to -22 (strong disinflationary pressures) – red line in the bottom section of the chart.
  • High inflationary pressures are signaled when the model rises to +6 or above.
  • Low inflationary pressures are indicated when the model falls to zero or less.
  • Signals are marked with up and down arrows in the upper section of the chart.
  • Current forecast is signaling rising inflation.

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Source: Ned Davis Research

I wrote a short paper some time ago called “Trend Following Works!”  Listed are numerous academic studies that look at individual stock as well as asset class price momentum that found trend following to be one of just a few investment factors that works consistently over time.

As a trading strategy, trend following is exceedingly effective and profitable over time.  Most strategies are straightforward in methodology and there are many individuals, past and present, famous or obscure, who have used trend following to success and riches.  Paul Tudor Jones and John William Henry II and his turtles come to mind.

But trend following requires, above all else, discipline, sound process and patience from the investor/trader/money manager.  Like the inflation process described above, the technical aspect of trend following is in fact quite simple and may produce a statistically significant 71% profitable signals that also means that 29% were not.  I’ll take the 50% long-term bet and the smoother ride to that win but that’s the point… stay with it.

A quick note on chart #1 above: the data in the chart does not include the reinvestment of dividends, so add in roughly 3% more to both sides of the return.  Same conclusion… trend following works.  *I don’t personally trade the inflation trend following process though it does help inform my work.  Another quick note, my fundamental view is that inflation may rise a bit and the debt bubble will bring inflation back down.  Hard to have inflation in a deleveraging world.  But my fundamental view could prove to be wrong.  I find it easier to follow a simple rules-based trend process.

I do see the potential, as Ray Dalio might say, for a “beautiful” way out of this debt mess.  Perhaps our world leaders can come together, hold hands, pinky promise never to do it again and forgive the debt.  Click.  Gone.  It would require strict agreement on currency controls so one country doesn’t cheat the others.  Could it happen?  Maybe…  Likely?  I have my doubts.

Might it work?  Not sure but the existing alternative is not so good either.  The movement towards protectionism is real so I’m not so sure the mood is right just now.  Anyway… we are currently seeing signs of inflation and the above model just signaled sell.  Keep it on your radar.

How do you size the above (should you favor that approach) and other processes into your clients’ portfolios?  Consider creating a core allocation that diversifies to a handful of trading strategies.  Perhaps 20% to 60% of your total portfolio.  You decide.  Do some analytics and see how it impacts your portfolios.

Why?  Equity market valuations are the second highest in history.  Why?  We are near 5,000-year lows in interest rates.  The 35-year bull market in bonds likely ended last July when the 10-year yield