Editor's note: Originally published on July 10, 2014
Aren't you glad you are a trend follower? Leaving aside the potential performance advantages of trend following for a moment, it is just less drama. Case in point, as a trend follower you can avoid getting caught up in the endless debate about whether or not the market is overvalued. Consider the following analysis from Barry Ritholtz:
It has become commonly accepted that stocks are very expensive, overbought and perhaps even in a bubble. JPMorgan Chase & Co.'s latest quarterly chart book (you can download it here) takes issue with those conventions.
As you can see from the chart above, U.S. equity prices closely match their long-term average price-to-earnings ratio of 15.5. That's precisely at fair value if you are comparing it to the Standard & Poor's 500 Index earnings-per-share average of analyst estimates for the next 12 months.
That is one of the most common ways to value companies, but there are plenty of other approaches that show stocks either over or undervalued.
It is commonly stated by those immersed in the valuation debate that valuations may not matter in the short-run, but they absolutely matter in the long-run. That may be true, but when it comes to your experience as an advisor with your clients, what are the practical implications of getting out the of the market 3 years (as an example) before the bull market ends? That's right, you get fired.
The principle of keeping it simple, has served us very well for almost three decades now. What is a trend follower's interpretation of the following chart of the S&P 500? A positive trend with no signs of deterioration at this point.
Source: Dorsey Wright, as of 7/10/14
This in no way negates the need for prudent financial planning and asset allocation. Nor does this make us perma-bulls. It does, however, make us pragmatic. As to whether or not trend following "works" I would recommend reading the following white papers by John Lewis:
- Point & Figure Relative Strength Signals
- Tactical Asset Allocation Using Relative Strength
- Relative Strength and Portfolio Management