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A Century of Evidence on Trend Following

AQR recently updated its paper A Century of Evidence on Trend Following and whilst the updated hasn’t changed the basic conclusion of earlier versions it is worth unpacking some of the main point of the paper.

The paper in its introduction makes an immensely important point that is lost on most –

As an investment style, trend following has existed for a very long time. Some 200 years ago, the classical economist David Ricardo’s imperative to “cut short your losses” and “let your profits run on” suggests an attention to trends. A century later, the legendary trader Jesse Livermore stated explicitly that the “big money was not in the individual fluctuations but in … sizing up the entire market and its trend.”

The thing I always find fascinating about trading, markets and people is that everyone is trying to reinvent the wheel. I understand this compulsion after all a new wheel sells but the basic technology of trend following and trading in general is as seen above centuries old. Yet these simple ideas somehow go by the wayside. Granted our own psychology gets in the way of following Ricardo’s simple missive of letting our profits run and cutting our losses short as we find being in the action more compelling than actually trading correctly. But even professionals have trouble following this rule as evidenced by the number of institutions who hold stocks as they grind their way into the ground.

In assembling the material for this paper AQR looked at the monthly returns for some 67 markets which were made up of four major asset classes – 29 commodities, 11 equity indices, 15 bond markets and 12 currency pairs. Which is no mean feat when you are going back a century. The results of this analysis can be summed up in few charts. To test the notion of trend following they adopted a simple strategy consisting of a 1- month, 3-month, and 12-month momentum strategy for each market. In this instance momentum does not refer to an indicator but rather price movement.  A long position was taken if the pat return over the look back period was positive, conversely a short position was taken if the return over the look back period was negative.

It’s a simple if it’s going up buy it, if it’s going down sell it strategy.

Position sizing was volatility based and the portfolios were rescaled monthly to make certain that the portfolio hit an annualised volatility target of 10%. Fees and charges were included in the testing.

Take home points

Trend following was profitable in every decade since 1880 as shown in the table below.

Exhibit 1

Trend following beats traditional 60/40 portfolios. The chart below looks at drawdowns during periods of financial stress. As can be seen trend following does very well during these periods. The authors posit that this occurs because of the simple ability of trend following to point themselves in the direction of the prevailing trend as dictated by Livermore’s dictum of deciding what the overall trend is.

Drawdowns

Trend following produces outsized gains when markets are moving. In developing a trading system traders often simply look at the overall return of the system and if it is positive then they are happy. However, of equal importance is how those returns are derived. It has been my experience that the majority of returns are generated in a cluster of individual returns, that is the entire portfolio doesn’t do well but rather pockets of the portfolio do extremely well and drag the average up. In trading you want a strategy that produces outliers when the opportunity exists – you have to be a pig when the opportunity to be a pig presents itself.

smile

The chart above illustrates this phenomena – the chart looks a little complex but it is only measuring two things. The performance of the US stock market on the horizontal axis and the performance of the momentum strategy on the vertical axis. The green line curving a path through the dots is known as a smile and it shows that trend following produces its best returns when markets are moving.  This harks back to the earlier point of being able to take advantage of market moves when they occur.

Trading is a simple profession since it can be summed up in three ideas. If it is trending up over the time frame you are trading you buy it.If it trending down over the time frame you are trading you sell it. Dont bet the farm. It is hardly rocket science yet despite this our very nature more often than not defeats us despite the evidence that it shouldn’t.

Does News Move Markets….Sort Of…Maybe…Well No Actually

I was chatting the other day with someone who was having trouble with their trading system. Their approach was based on trading news events. Such a plan is predicated on the notion that news events move markets in certain ways and whilst this movement might not be wholly predictable it will at least generate some form of activity. Such a trading system has a single giant assumption – that news and news related events move price. If this maxim does not hold up then the system is a bust.

It has been sometime since I looked at this question and I had a vague recollection of research done in the 1980’s that looked at this question and found that news as a source of trading ideas was a bust. So armed with the dimmest of memories I went looking through my archive and found what I was looking for. David Cutler, James Poterba and Lawrence Summers produced a working paper titled What Moves Stock Prices for the Department of Economics at MIT in 1988. This paper looked at the 50 largest single day moves in the US market since World War Two – I have included the events from the original monograph below.

Event 3

If you take a cursory look at the events above you could argue that news events do move markets. However, there is a glitch in that some movements defy explanation – there is simply no event that can be seen as a casual trigger for a market move. Cutler et al stated that news events could really only be useful as an agent for movement in about half of all cases of the variance in stock price movement and in my world half is a fluke.

The interesting side issue with the work of Cutler et al is that it puts another hole in the Efficient Market Hypothesis because stock price movements according to the EMH reflect the assessment of investors to new information. If markets move without the the addition of new information to the system then something else is happening that is not explained by the EMH. And it seems in the case of broad brush analysis as performed by Cutler that prices move without any significant input.

This initial work has been expanded upon by Ray Fair at Yale University who looked at outsized movements in the S&P500 futures contract. This new work had much greater granularity to it in that it looked at five minute data, something that would have been difficult in the original work by Cutler and crew simply because the available technology would not have allowed it. Fair compared what he defined as big movements with news items emanating from the Dow Jones News Service, Associated Press and New York Times. The upshot of this investigation seemed to be that the majority of large events have no news based driver. They were only able to attribute a news item to 69 of the 1159 big moves that were examined. Recent  flash crashes seem to support this notion of significant market moves  occurring without a notional driver.

So we come back to the original assumption that news events drive markets and that these moves offer opportunities that can be traded. It would seem on the evidence available that this notion is false.

Gold Vs S&P500

I am still intrigued by the US markets reaction to the results of the US election when viewed in tandem with an instrument such as gold which is generally seen as a hedge against uncertainty (in this instance read outright dickheadedry) As such I though I would look at the relative returns of both instruments over a series of times frames if that told me anything about the market currently being uncertain about its own uncertainty. In looking at these two instruments I have cheated a little bit in that I am using a proxy for gold. I am using GLD which is an ETF that tracks the physical price of gold. I accept that this is a broad brush approach given the nature of the construction of GLD. However, I am looking for at a battleaxe approach not a rapier so the small inconsistencies dont bother me. I am more interested in looking at the broad pattern. If you have to look too hard then there is no pattern at all. If the relationship is not then when being as subtle as a sledgehammer then it is not there at all.

The firts thing I wanted to do was to look at the relative performance of the two since the US election and this can be seen in the chart below.

gld 1

My reading of this from left to right is that Trump wins the election and the long term rally that has been in place since 2009 reasserts itself with equities taking off and GLD drifting. A few weeks later the ramifications of electing a buffoon become apparent and the market stalls and GLD rallies slightly. We now have the situation where the market is rallying in the short term as is GLD. A cynic might suggest that trades are hedging their bets a little.

However, it is important to note that these sorts of performance comparisons are dependent upon the starting date. If I roll the starting date back a year a different picture emerges.The big picture alters every time you change the starting date.

gld2

We can see that GLD actually begins to drop off in the second half of 2016 as physical gold runs into a wall and begins to fall back. The out performance of the S&P500 over this time becomes even more apparent but the bounce in GLD is still there but the performance of the S&P500 is so much more apparent. This raises the question as to whether this sort of analysis whilst mildly interesting on an academic basis actually provides any insight that is worthwhile. Such a question also highlights a simple fact of analysis and of system design in general. Everything you do needs to add some form of value to the system. Unfortunately academic interest does not add value to a system so on this basis my feeling is that this sort of thing doesn’t add any value outside of curiosity and the vague conclusion that traders are uncertain about being uncertain. To be blunt you have to ask the question does it help make money since that is the aim of trading. For some it might but for me it just kept me occupied for half an hour.

 

 

 

No Man Is An Island

So said John Donne and the same is true of markets. One of the most fascinating features of trading is that markets at times they display interesting interrelationships and that these relationships tell you something about the underlying emotional state of the market. Below are three markets I am currently involved in and all seem at this point in time to be telling a story about how the market is currently coping with a President – Elect who seems to have the IQ of a trout and the stability of a slinky falling down Mt Everest.

Markets

As  personal disclaimer I am currently long gold, short the USD in various iterations and my short term Dow system just threw me out from my last long position. So this is my story so it reflects my internal bias. What is interesting is that the Dow didn’t power through 20,000. I remember when it hit other “significant” numbers and it just burst straight through – there was no prevarication or hesitation. Yet at the same time the Dow paused gold began to move up and the USD Index began to move down. Whilst is is interesting to try an assemble a narrative from this – it is easier to simply trade the charts and let others build a narrative as to what they mean.

As a final point it is worth looking at how a few major markets have performed YTD – as you can see precious metals seem to be doing a fair bit of heavy lifting.

YTD

 

The Year That Was.

It is that time of the year when everyone involved in this business looks in the rear vision mirror and attempts to make sense of what happened.  And of course to everyone involved everything is so obvious and predictable. What is worse is that they take this data and attempt to make some form of prediction about the year ahead. Hindsight is all we have and whilst it is the perfect investment tool; we are denied its luxury in the real world. Even looking at a league table of performance of various instruments is somewhat meaningless. However, since they are all the rage below is one such table I quickly knocked up for a few common instruments.

League Table

Part of the problem is that these tables are looked at from the perspective of the buy and hold investor. It is assumed that you simply bought one of everything last year and held onto it and your performance either good or bad is a function of this. However, this is not how trading works. For example the AUD/USD began the year with a 15% gain, which is then gave back and settled into a meandering decline resulting in its ordinary year on year performance. Likewise all the gain in heating oil came in the first half of the year. Conversely, cocoa which turned in a shocker traded in a range for most of the year and then collapsed in October.

Whilst it is twee to say so in trading only the journey counts not the destination, in fact I would go a little bit further and say that even the starting point is irrelevant. As such tables such as the one above whilst vaguely interesting are essentially irrelevant to us.

The Year In Money

Bloomberg have been busy – click the image below to be taken to the full infographic.

2016

Inside a Moneymaking Machine Like No Other

That’s because the area’s wealthiest residents, scientists all, work for the quantitative hedge fund Renaissance Technologies, based in nearby East Setauket. They are the creators and overseers of the Medallion Fund—perhaps the world’s greatest moneymaking machine. Medallion is open only to Renaissance’s roughly 300 employees, about 90 of whom are Ph.D.s, as well as a select few individuals with deep-rooted connections to the firm.

The fabled fund, known for its intense secrecy, has produced about $55 billion in profit over the last 28 years, according to data compiled by Bloomberg, making it about $10 billion more profitable than funds run by billionaires Ray Dalio and George Soros. What’s more, it did so in a shorter time and with fewer assets under management. The fund almost never loses money. Its biggest drawdown in one five-year period was half a percent.

“Renaissance is the commercial version of the Manhattan Project,” says Andrew Lo, a finance professor at MIT’s Sloan School of Management and chairman of AlphaSimplex, a quant research firm. Lo credits Jim Simons, the 78-year-old mathematician who founded Renaissance in 1982, for bringing so many scientists together. “They are the pinnacle of quant investing. No one else is even close.”

More here – Bloomberg

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.