John Hussman: The Trend Is Your Fickle Friend

 |  Includes: DIA, QQQ, SPY
by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (08/27/12):

One of the questions we often receive is why we don’t simply lift our hedges when the market advances above some moving average or another, and replace them when the market breaks below those moving averages. Certainly, when one looks a chart, extended market advances always break above various moving averages, and extended market declines always break below various moving averages, so simple trend-following strategies seem utterly self-evident. Unfortunately, if you actually take that strategy to historical data, the results typically aren’t nearly as compelling. Moreover, once any amount of slippage or transaction costs are taken into account, the most widely-followed strategies generally underperform a passive buy-and-hold strategy over time, and often don’t even manage downside risk particularly well.


I am comfortable with the tracking risk that our own hedging strategy experiences because I believe that we can reasonably target full-cycle returns substantially above a passive buy-and-hold approach, with significantly reduced drawdowns. We’ve achieved both objectives in prior market cycles, measured from bull-market peak to bull-market peak, or bear-market trough to bear-market trough. But this was not the case in the 2007-2012 cycle, due to missed returns in 2009-early 2010 as we worked to make our approach robust to Depression-era outcomes. From a fiduciary perspective, I continue to believe that ensuring the ability to withstand extreme strains was necessary. From a practical perspective, I continue to believe that the ability to withstand extreme strains will be more relevant in the coming years than investors would presently like to believe.


So what is the difference between mediocre trend-following measures and more historically useful approaches? The key issue here goes back to what I’ve always emphasized about “signal extraction.” Generally speaking, single indicators provide weak information because the true signal (whether about market conditions or economic prospects) is invariably confounded by random noise. The ability to infer signals from noisy observable data is typically enhanced by using a variety of indicators. Nearly all modern signal processing – in fields as diverse as radar tracking, MRI scanning, and genetic analysis - is based on the observation that multiple sensors are best suited to picking up true signals in the presence of random noise. Just as we find for economic data, market action should always be analyzed in the context of multiple indicators that capture a broad range of sectors, security types, yield-spreads, leadership, and so on. The information isn’t just in the obvious trends, it is also in the less obvious divergences.


I’ll add as a side note that veteran Dow Theorist Richard Russell expresses enormous concerns today about market action, partly (though certainly not entirely) because of the joint breakdown in the Industrials and the Transports a few months ago, and the subsequent failure of the Dow Transports to confirm the rally in the Dow Industrials since then. Price-volume behavior is also problematic here. As William Hamilton observed a century ago, a market that becomes “dull on rallies and active on declines” should not be trusted. From that standpoint, the wholesale collapse of trading volume in recent weeks is almost creepy.