Simple Strategies To Capitalize On Market Trends

 |  Includes: WDTI
by: Efficient Alpha

By Peter Pearce

This is part of our series exploring the myths in popular investing as exposed in Michael Dever’s new book, Jackass Investing. In the book, Dever uses experience from three decades of hedge fund management to explore how the conventional wisdom in investing and portfolio management preaches little more than gambling.

Myth #7, “It’s Bad to Chase Performance,” is the target of the day. Chasing performance is often referred to as “momentum trading” and involves taking long and short positions in the market to capitalize on trending market behaviour. Momentum traders look to find stocks that are moving significantly in one direction and try to jump on board to ride the market until the momentum stops.

This myth exists because there are countless stories of individuals who jumped on board an investment while it was trending upwards and were subsequently devastated by its collapse. The late '90s rally in technology stocks is one of the most infamous as investors chased the tech market’s rally, turning thousands into millions, but ultimately into pennies when the trend ended. They believed that because the tech market had performed well, it would continue to perform well.

But the problem for these investors was not that they had chased performance, but rather that they had no exit strategy. Investors who chase performance without a plan create the trend by jumping in at the top and lose money by getting out at the bottom. Sooner or later, all trends end, and dealing with transitions and trend reversals is a pivotal component of any portfolio strategy. We’ll outline a simple strategy to exploit this trending behaviour later in the article.

Markets trend because investors have biases, such as: Anchoring Bias (investors rely too heavily on prior price history, discounting new information), Confirmation Bias (investors look for information that supports their own belief about the market) and Herding (tendency of investors to act as a group and jump on the bandwagon). The herding behaviour is a main driver for trend continuation, as this behaviour can feed on itself, further propelling the trend. Investors believe that markets that have performed well in the past will continue to perform well, while those that have performed poorly will continue to perform poorly, even without underlying fundamental reasons. Dever explains: “Trends exist and are perpetuated because winning behaviour is reinforced, even if it’s wrong.”

If you’re still not a believer that these market trends exist and need statistical evidence of them, consider the graph below. It’s a great bar chart from Jackass Investing that shows a distribution of monthly percentage moves that the S&P 500 has made over the last 60 years.

Click to enlargeA “normal” distribution of returns would look like a perfect bell-shaped curve, but this graph is clearly is not “normal.” It displays a negative skew, which means the left tail of the distribution is larger than the right tail. These “left tail” outcomes reflect negative returns and portfolio losses. This series will also touch on the evidence that the returns of the stock market are skewed more towards being negative. Missing the ten “worst” and ten “best” market days would actually result in better portfolio performance than if you had been in the market. The distribution also displays “positive kurtosis,” which means it has fatter tails than a normal distribution would. A perfectly bell-shaped curve would indicate that monthly returns are randomly distributed, but both the negative skew and the positive kurtosis are evidence of trending market behaviour.

Lucky for us, there is a simple way to capitalize on trending market behaviour through index funds. The S&P Diversified Trends Indicator, DTI, is an index designed to capture the profit potential of price trends. It uses a simple trend-following strategy to take long or short positions in 24 commodity and financial futures contracts. The strategy is very simple: At the end of each month, the strategy checks to see if the price of each market is above or below the 7 month exponential moving average. If the price is above the moving average, then a long position is taken in the futures market; if the price is below, then a short position is taken. Don’t let “7 month exponential moving average” scare you; it means the average price in the last 7 months, with the recent months weighted more heavily than older months. For example, as of Oct. 20, the DTI is short grains, industrial metals, precious metals and soft commodity futures, while being long livestock and flat in energy. With the ability to go both long and short, the S&P DTI was designed to capture the economic benefit derived from both rising and declining trends within these futures markets.

During bear markets, the correlations of equity markets “go to one” and the value of all equity falls together. This correlation in equity markets during the time you need diversification the most makes it ultimately important to diversify away from equity to other asset classes that are not subject to the same underlying risk. The S&P DTI trades in the following sectors: Energy*, Industrious Metals, Precious Metals, Livestock, Grains, Softs, Currencies, U.S. Treasury Notes and Bonds. The non-correlation between these very different markets provides it much more diversification than equity markets as the prices of these futures move independently of each other This effect results in the lower volatility of the S&P DTI that is evident in the graph below.

*S&P DTI does not trade energy short, but enters into a flat (i.e., neutral) position instead.

Click to enlarge

Below is the performance of the S&P 500 TR, from January 1988 to December 2010, compared to the S&P DTI (data is back-tested prior to 2004):

Click to enlargeDever prefers to use the maximum draw-down as his measure of risk because “the draw-down (maximum peak-to-trough loss) is a true measure of pain felt by a person while holding a position.” Regardless of which measure of risk is chosen, the S&P DTI delivers much better return/risk performance. The annual return of the S&P DTI is only 1% lower than the S&P 500, but has 58% lower volatility and a max drawdown 67% smaller.

There are two funds available that replicate the performance of the S&P DTI index. The first is an ETF released in January 2011, the WisdomTree Managed Futures Strategy Fund (NYSEARCA:WDTI). The alternative is the mutual fund Rydex Managed Futures Strategy Fund (RYMFX). The WDTI has an expense ratio of 0.95% compared to the 1.99% for the RYMFX fund, and since they both track the same index, I would recommend the WDTI.

Implementing the trending strategy of the S&P DTI is also possible without the use of a replicating fund. For example, consider using a very similar market timing strategy in your equity allocation. The strategy is simple: verify the price of indexes you hold at the end of each month, and if the price is above the 200-day moving average, then keep your long position in the index. When the price falls below the 200-day moving average, either enter into a short position or close the positions and move the funds to cash. This type of strategy can easily be accomplished through a discount brokerage and materially improves the returns of just buying and holding the index.

The goal is to create a simple-to-follow method for managing risk in a portfolio. Employing a market timing solution is an effective way for investors to side-step many protracted bear markets. The results of the S&P DTI and other simple trend following techniques compare favourably to the performance of the overall market. Please note that this strategy should not be used as the sole basis of returns in your portfolio, but rather in combination with several other strategies following different return drivers. This is really the thesis to the book, that investors can create a portfolio with enhanced returns and lower volatility by combining different strategies.

Visit our website for a complete list of articles in the series so far and action strategies you can use in your portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This series has been written on a contracted basis with the book's author. The opinions expressed in the article are those of Efficient Alpha and not necessarily those of the book's author. Efficient Alpha has been contracted to describe strategies and concepts used within the book, but not to promote or recommend any strategies, the author, or the author's services.