Introduction

As I am fond of saying, when it comes to investing methods, especially in equities, we really only have three choices: 1) Emotional Investing, 2) Buy and Hold, and 3) Rules-Based Investing.

The first one clearly doesn’t work as investors will typically buy high and sell low. This has led many to conclude that market timing doesn’t work as most people going in and out of the market are using emotionally based reasons and are worse off than if they just used buy and hold. The second option, Buy and Hold, does work as an investment strategy, especially if you are a foundation or have an extremely long time frame, and have an iron stomach for long down markets. The final option is one I call rules-based, and it covers many various strategies. The key is that the decisions are tied to unemotional triggers. For example, an investor could simply be long US equities whenever the Trailing Price to Earnings Ratio ratio drops below 15 and be in cash or bonds whenever the ratio gets to 20.

The rules-based strategy we use is most commonly known as trend-following. In the academic literature you will also see reference to moving average crossover (MAC) since the category of trend-following we employ uses equity prices that cross over a moving average to make a decision on whether to initiate or exit a position. In essence, the price of the security crossing above or below its long-term trend makes the rules-based strategy an unemotional decision.

As you can see in Chart 1 from JP Morgan, while the S&P Composite generally rises over time, there are times in which the market makes very little progress for very long periods of time (e.g. 1901-1924, 1966-1982, 2000-2012.) We get fooled by the 10% long-term average rate of return into thinking that the next 10 or 20 years has to be around that average. Not only is that not necessarily true, but if we are living on our assets, it is a dangerous line of thinking. Look at Chart 2, also from JP Morgan. An investor going long the S&P Composite (it is not possible to invest directly into an index) at the peak of the market in 1929 did not break even until 1954, 25 years later! Yikes! And lest we think that this market behavior no longer applies in the modern age, keep in mind that as of June 2016 the Nasdaq index was still below its peak in 2000, 16 years prior.

Chart 1: Stock market since 1900

Chart 2: Bear markets and subsequent bull runs

As I mentioned a moment ago, these long drawdowns are especially dangerous for those who are living on their investments. As you can see in Chart 3, while an investor only needs to gain a 25% return to recoup from a 20% loss, if he is drawing at a 4% clip per year over three years he will need a 42% increase to get back to even. No wonder those who retire right before bear markets have such a difficult time making their money last.

Chart 3: Mathematics of Loss

Trend Following

Trend following gives us the opportunity to reduce the massive drawdowns that typically permanently damage wealth. The next few charts were derived from an Excel spreadsheet designed by Mebane Faber (mebfaber.com). The blue line (B&H) is the results of the index for buy and hold; the red one is for timing (equity curve in Meb Faber’s lexicon) and the gray is for timing after fees of 1% annually. The “timing” checks the price of the index at the end of each month and if it is above the 12-month simple moving average, it is long the index for the next month; if it is below the 12-month simple moving average, it is invested in the 10-year Treasury Bond Index for the next month. The charts show the thirty year results of various indices from 12/31/85-12/31/15. This is a time-frame that includes a secular bull market and a secular bear market and several cyclical bull and bear markets within the secular cycles. It includes the crash of 1987, the dot com bubble and bust, the housing bubble, and the Great Recession.

Chart 4: S&P 500, 12/31/85-12/31/15

This shows the result for the S&P 500.

The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

Chart 5: S&P 500, 12/31/99-12/31/15

If we zoom into the 12/31/1999-12/31/2015 period, we can see the potential reduction of massive drawdowns more clearly.

Chart 6: MSCI EAFE, 12/31/85-12/31/15

This is for developed foreign stocks.

The MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada.

Chart 7: NAREIT, 12/31/85-12/31/15

Results for Real Estate Investment Trusts (REITS).

The NAREIT EQUITY REIT Index is designed to provide the most comprehensive assessment of overall industry performance, and includes all tax-qualified real estate investment trusts (REITs) that are listed on the NYSE, the American Stock Exchange or the NASDAQ National Market List.

Chart 8: Gold Spot, 12/31/85-12/31/15

Results for Gold.

Finally, this is what a diversified index mix of 50% S&P 500, 20% developed foreign stocks, 15% REITs, and 15% Gold would have looked like. This assumes annual rebalancing for Chart 9.

Chart 9: Diversified Mix, 12/31/85-12/31/15

Diversified Index Mix (50% S&P 500, 20% MSCI EAFE, 15% NAREIT, 15% Gold Spot), 12/31/1985-12/31/2015.

Buy & Hold Versus Timing Mix Here are a few statistics for the buy & hold mix versus the timing mix:

So the 30 year results after 1% annual management fees are, hypothetically, a 17% improvement in returns, a 25% reduction in volatility as measured by standard deviation (37% reduction of downside volatility), a 70% improvement in the Sharpe Ratio, and most importantly in my opinion, a 70% reduction of the maximum drawdown.

Weaknesses and Frustrations

This is not a panacea for investing. There are many weaknesses and a number of frustrating side effects with trend following. Generally speaking, trend following historically will lag in bull markets and historically will prosper in down markets. Here are a few things to consider:

• Friction or slippage. The above examples assume you were able to make the changes immediately. In reality, there will likely be a one-day delay.
• Tax consequences for taxable accounts would likely reduce returns. Fees for trades or wrap fees could be higher than in the above examples and would have reduced returns.
• Indexes versus investable vehicle. This hypothetical uses indexes. Passive investment vehicles have fees and would have lowered returns. Active vehicles have the potential to generate both higher and lower returns than illustrated.
• Whipsaws. The biggest headache for many will be getting into an asset class only to get back out one or two months later with no progress. Even worse is when you buy back into an asset at a higher price than you sold it.
• Occasional poor relative short term returns. There will be times when for several years due to some whipsaws this strategy will trail the buy and hold investor. This is where many will be tempted to give up. Notice also trend following does little for one day crashes like in October of 1987.
• Trend following out of favor. Our research shows that there are long stretches, even up to a decade, in which trend following adds very little or even detracts from returns.
• Past Performance is no guarantee of future results. The foregoing has been entirely historical. While there appears to be substantial persistence in the success of trend following over the long run, it is entirely possible that it will cease to hold true.

Conclusion

The bottom line is we are attempting to gain 80% of the market’s upside while avoiding 80% of the downside. There is no guarantee we can achieve this, but the first principle of wealth accumulation is wealth preservation. We believe using rules-based trend following as part of a total investment strategy is worthwhile.

Definitions from Investopedia

Compound Annual Growth Rate (CAGR): The compound annual growth rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer than one year.

P/E Ratio: The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.

Simple Moving Average (SMA): A simple moving average (SMA) is a simple, or arithmetic, moving average that is calculated by adding the closing price of the security for a number of time periods and then dividing this total by the number of time periods. Short-term averages respond quickly to changes in the price of the underlying, while long-term averages are slow to react.

Standard Deviation: Standard deviation is a measure of the dispersion of a set of data from its mean; more spread-apart data has a higher deviation. Standard deviation is calculated as the square root of variance. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility.

Sharpe Ratio: The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-free rate from the mean return, the performance associated with risk-taking activities can be isolated. One intuition of this calculation is that a portfolio engaging in “zero risk” investment, such as the purchase of U.S. Treasury bills (for which the expected return is the risk-free rate), has a Sharpe ratio of exactly zero. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.

Sortino Ratio: A modification of the Sharpe ratio that differentiates harmful volatility from general volatility by taking into account the standard deviation of negative asset returns, called downside deviation. The Sortino ratio subtracts the risk-free rate of return from the portfolio’s return, and then divides that by the downside deviation. A large Sortino ratio indicates there is a low probability of a large loss.

Maximum Drawdown: A maximum drawdown (MDD) is the maximum loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum Drawdown (MDD) is an indicator of downside risk over a specified time period.

Bibliography

Faber, Mebane T. “A Quantitative Approach to Tactical Asset Allocation”, 2013. J.P. Morgan, Guide to the Markets® 3Q 2016. Otar, Jim. Unveiling the Retirement Myth, Otar and Associates, Inc., 2009. Wong, Theodore. “Moving Average: Holy Grail or Fairly Tale – Parts 1, 2, and 3”, Advisor Perspectives, Inc. 2009.