“The trend is your friend except at the end where it bends.” – Ed Seykota
Many traders are familiar with the adage “the trend is your friend.” However, investors are more aware of Wall Street’s “buy and hold” mantra which is widely believed to be the only way to achieve attractive long-term risk adjusted returns. Since 2009, US equity markets have experienced their longest bull market ever, shrugging off every bump in the road with the help of an accommodative Central Bank. During this time, index funds have become the vehicle of choice. Therefore, should investors just buy and hold or are there reasons to invest with the trend?
Let’s revisit the last major US stock market dislocation, the Global Financial Crisis, to help determine if investing with the trend can add value. From 2003 to 2007, stocks were in a bull market rising off the depths of the dot com bust, the 9/11 terrorist attacks and the accounting scandals of Enron and WorldCom. The Federal Reserve had cut interest rates to cushion the blow and the economy was on the mend. Prolonged low interest rates arguably helped kick off the housing bubble that followed. Stocks boasted a 14.24% CAGR (Compound Annual Growth Rate) and experienced a maximum drawdown (peak to trough loss) of 5.62%.
The Global Financial Crisis took hold of the global economy in 2008 and markets suffered a severe blow. The S&P 500 fell by more than 50% (daily data) and fear overwhelmed investors, causing some to exit at the lows and not reenter the markets for years. Nearly half the returns of the prior 5 years vanished.
What if an investor followed the trend of the market and moved to cash when the trend turned lower (also known as trend following)? A common definition of the long-term trend is the 10-month moving average of a market. When the price is above the 10-month moving average, the trend is up and vice versa.
The trend of the S&P 500 turned down in December of 2007, well ahead of the severe damage that was to come. Not only was the damage financial, riding a massive bear market all the way down tests one’s nerves and adds tremendous emotional stress. Bear markets feed on fear which exacerbates the move lower adding to losses and frustration. Moving to the sidelines can bring peace of mind and reduce stress.
Investing with the trend paid off during the Global Financial Crisis and allowed investors a CAGR 54% higher than buy and hold, 48% less volatility measured by the Standard Deviation of returns and an 86% reduction in the maximum drawdown.
Investing with the trend is a discipline that works over time not all the time. If you are interested in learning more about the long-term consequences of investing with the trend in the current market environment, exploring implementation of trend following strategies on additional asset classes and ways to harness the process to reduce risk and enhance returns, then I encourage you to subscribe to weekly updates from us posted every Thursday.