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Confirmation: Trend Following Can Help You Avoid Bear Markets

I like to follow the various pieces put out by other trend followers to see if there is anything I can learn or use to help others. Recently I ran across an interesting piece on called "Avoid Bear Markets To Beat The Index."

Now you have to know that this is something that I have been saying for years that if you are an equity trend follower (someone who practices trend following but on the equity stock markets) that you tend to underperform due to false alarms and exaggerated market movements on the way up (the bull market phase), but outperform in the bear market, which makes up and then some for the underperformance in the bull phase of the market.

ACIES Asset management wrote the article and they contend the following:

  • Classic trend following (like models will fail on stocks (I disagree with this…see my comment above);
  • The high correlation between stocks goes again the core assumption of diversification on which classic trend following relies (I agree with this at times);
  • Stocks tend to act as a group, particularly in bear markets; (yes, this is true);
  • The long side will make you money, but the short side will lose it (totally disagree!);
  • By cutting away the short side completely, trading only longs, we get a slow and steady outperformance of the index. (this is ok, but you do give up some potential upside).

Finally, they says "outperformance has a large beta component."

My comments are in the parenthesis above. Obviously, I disagree with some of their summary findings. Most troubling to me is the the "long side is the only side" thesis which to me sounds more like a long-only trend follower trying to justify how they manage money.

I do agree that being short, even for brief periods, in a rising bull market will likely cost you money. You just need to see the last three or four years returns for most trend followers for proof of that fact. However, what I won't agree on is that the short component won't also make you money in a bear market. Here is the thing, the trend follower that utilizes shorts MUST BE WILLING TO ACCEPT THE SHORT SIDE VOLATILITY AND BE WILLING TO SEE SOME OF THE GAIN GIVEN BACK FROM TIME TO TIME WHEN MARKETS TURN OR BOUNCE.

If you can accept the former, the short side does work as evidenced by the S&P 500 model we run:

In the article, ACIES goes on to provide their evidence utilizing a trend following simulation model (if you are interested in this check out the article link above) and then they provide the following results (which is really what I wanted to share with you today):

The key is pretty hard to read! The blue line represents the index with a filter. This filter is that long only positions are allowed with the 50 day exponential moving average (NYSEMKT:EMA) is above the 100 day EMA and vice versa. Positions are entered on the 50 day breakouts in the direction of the trend and position sizes are set to five basis points using an average true range of 50 days. They also considered the entire S&P 500 constituents for timing, no leverage was employed and dividends were disregarded.

The red line is the S&P 500 price index and finally the green line is this strategy without the index filter of the 50 day EMA being above the 100 EMA.

So what do we see? This simple trend following strategy (blue line) did better than over overall index (red line), but its main outperformance came in the bear markets. Something we have discussed many times here on this site!