By Alan Gula, CFA
Paul Tudor Jones (PTJ), a legendary trader and hedge fund manager, essentially predicted the stock market crash of 1987.
In a PBS documentary, PTJ asserted, "There will be some type of a decline, without a question, in the next 10 to 20 months… it will be earth shaking… it will create headlines that will dwarf anything that's happened up to this point in time."
On October 19, 1987 the S&P 500 dropped 20.5% in a single day. Many investors were eviscerated, and some traders were completely wiped out. That month, PTJ's fund was up an astonishing 62%.
PTJ is an ardent proponent of trend following. That is, you always want to be positioned with the prevailing price trend. If a security or futures contract is trending higher, then be long. If it's trending lower, get flat (no position) or be short.
So how do we determine the predominant trend?
In an interview with Tony Robbins for Money: Master the Game, PTJ revealed that his preferred metric is the 200-day moving average of closing prices.
Regarding the 1987 crash, Robbins asked, "Did your theory about the 200-day moving average alert you to that one?"
PTJ responded, "You got it. It [equity index] had gone under the 200-day moving target. At the very top of the crash, I was flat."
The following chart helps illustrate what PTJ saw:
Trend following has been around for ages. But now funds are popping up that automate the process.
For example, the Pacer Trendpilot 750 ETF (BATS:PTLC) was launched in June 2015.
This exchange-traded fund (ETF) alternates exposure to the Wilshire U.S. Large-Cap Index (Index) or U.S. Treasury bills (T-Bills) depending on the trend indicators.
Here are the allocation rules:
- Positive Trend Established: When the Index closes above its 200-day simple moving average (NYSE:SMA) for five consecutive trading days, the exposure of the fund will be 100% to the Index. In other words, the fund will be fully invested in equities.
- Negative Trend Established: When the Index closes below its 200-day SMA for five consecutive trading days, the exposure of the fund will be 50% to the Index and 50% to 3-month T-Bills.
- Negative Trend Confirmed: When the Index's 200-day SMA closes lower than its value from five business days earlier, the exposure of the fund will be 100% to 3-month T-Bills.
These rules are designed to keep the fund invested when the stock market's trend is up but to protect capital with the safety of T-Bills during down trends.
Also, the rules attempt to minimize fund turnover during periods of high volatility.
PTLC seeks to replicate the performance of a trend-following index. The chart below shows its back-tested results.
The trend following index has outperformed over the long term with much smaller drawdowns (peak-to-trough declines).
The benefits of trend following as a form of risk management can clearly be seen during the equity bear markets in 2001-2002 and 2008-2009 (yellow circles).
The expense ratio of 0.6% for PTLC is a bit high, but the ETF does conveniently simplify the trend-following process.
It's worth noting that the ETF's current exposure is 100% T-Bills, meaning that a stock market downtrend has been confirmed.
The 200-day moving average is such a simple indicator that few people believe it offers valuable information. Also, with so much focus on daily catalysts and short-term moves in the media, the big-picture trend gets lost amid the din.
The last time the S&P 500 crossed below its 200-day SMA was at the very end of 2015.
I doubt PTJ was caught off guard by this year's 10.5% decline through February 11.