THIRTY YEARS OF TREND FOLLOWING OF THE S&P 500
There are several ways to trade and invest in the stock market. An investor may conduct in depth research into the fundamental strength of individual companies before selecting securities or base their decisions solely on the current trading price, while a savvy hedge fund manager may utilize the information gathered by a team of analysts. Whichever method you adopt, one method stands out to me as an investor, trend following and trend trading.
Trend trading was popularized in the 1980’s when Richard Dennis and Bill Eckhardt recruited and taught a small group of traders, known as the Turtle Traders, a trend trading strategy that netted them more than US$100 million in profit.
What is trend following? To put it simply, “A trend is a general drift or tendency in a set of data. All measurements of trend involve taking a current reading and a historical reading and comparing them. If the current reading is higher than the historical reading, we have an up-trend. If lower, we have a down-trend. In the improbable event of an exact match, we have a sideways trend. The direction of the trend depends upon the method we use to perform the comparison. Real instruments fluctuate minute-to-minute, day-to-day and year-to-year. We have, therefore an enormous supply of historical points to use to determine trend… All methods of defining trends compare various combinations of historical price points. All trends are historical, none are in the present...When we speak of trends, we are speaking, necessarily, from some or another view of history...” -Ed Seykota
This strategy called trend following attempts to capture gains through the analysis of a security's momentum in a particular direction. In general, trend traders enter into a long position when a security is trending upward (e.g. successively higher highs) and/or enter a short position when a security is trending lower (e.g. successively lower highs). The bottom line is markets move upwards, downwards and sideways, they form trends and they flow. Trend trading assumes that a security will continue to move along its observed trend and may contain a take-profit or stop-loss provision if there any indicators of a reversal in price. Whatever stock market you’re examining, it’s guaranteed they all share one commonality, price. You can invest in any stock, in any market, knowing absolutely nothing about its fundamentals and still make a profit if you can look at price movements and price trends to make an informed prediction on future movements.
How do we go about identifying the trends in the S&P 500 (SPX)? One way to do so is through the use of a moving average. A moving average is simply the sum of the most periods divided by the number of periods. For example, a SPX 12 month moving average is the sum of the closing prices of the last 12 months divided by the number of months, in this case, 12.
Because this strategy is based on historical data, let us take a look at the performance of the S&P 500 over the last 30 years. The SPX is one of the most widely quoted US Indices because it represents the largest publicly traded corporations in the US. The SPX uses a market capitalization weighting method, giving a higher percentage allocation to companies with the largest market capitalizations. What does this mean? A price change in one of the largest companies in the index will have a far more significant impact on the SPX than a price change in one of the smaller companies listed in the index.
Graph 1 – S&P 500 30 Year Performance and its 12-month Simple Moving Average
As shown in Graph 1 above, there are two major declines over the last thirty years. They were the dotcom bubble burst in the late 1990’s and the mortgage bubble burst that triggered a financial crisis in 2007. These periods were preceded by bull markets where there were above-average investments into both internet-based companies and financial institutions and their associated product offerings.
An investor following the trend would have noticed around these declines/pullbacks, the trading price, falling below the 12-month moving average, at the bubble burst. A keen investor would have taken the cue to exit the market at this point and cash out his or her earnings.
The technical analysis adage thus comes to mind on the topic of trend following, ‘Whipsaws can be weathered, corrections are necessary, bear markets should be avoided’. Trend following allows an investor to make informed decisions in the market and therefore allow for an appropriate action to preserve value in their portfolio.
Below are the results for a trend following strategy, using the 12-month moving average of the SPX over the last 30 years:
Graph 2 - Inner Sample (1988-2010)
Graph 3 – Outer Sample (2010-2018)
Volatility has consistently moved with downturns in the SPX. When graph 1 is compared with graph 4, spikes in volatility coincide with downward movements in the SPX.
Graph 4 - VIX (1988-2018)
What does all this mean for predicting market movements? Trend following can be the difference between accepting a 20% loss versus a 5% loss or vice versa. It gives the investor a cue as to how to react to what’s going on in the market.
Based on what happened in the SPX for 30 years, if a novice or expert trader were to react based on the cues in the market they would have successfully entered and exited before they lost their accumulated gains over time due to recessions and downturns in the US economy.
Trend following does not necessarily have to be utilized as a stand-alone strategy but can be incorporated into a bigger strategy which may involve sector rotation, fundamental analysis, technical analysis, swing trading etc. However, you choose to invest, trends are an indisputable reality in the market and an alert investor can cash in on this basic way of observing market movements.