The Good, Bad and Ugly of Trend Following

The Good, Bad and Ugly of Trend Following

By Justin Carbonneau (@jjcarbonneau) —

Something has happened recently that hasn’t happened in quite some time – of the seven major market indices we apply our trend following model to we are now are seeing a SELL signal on all of them. Whether or not this is a harbinger of deeper losses or a run-of-the-mill correction is yet to be determined but I thought this would be a good opportunity to discuss the pluses and minuses of using trend following and the areas of the market where trend following may be more (or less) effective.

Asset ClassInception DateCurrent SignalLast Signal Change
S&P 500 (^GSPC)1/6/1971SELL4/13/2022
Russell 2000 (^RUT)9/11/1987SELL4/7/2022
Developed International (VEA)7/27/2007SELL4/13/2022
Emerging Markets (VWO)3/11/2005SELL2/24/2022
NASDAQ 100 (^NDX)10/2/1985SELL4/7/2022
Dow Jones (^DJI)1/30/1985SELL4/21/2022
MSCI EAFE (EFA)8/28/2001SELL4/13/2022

Source: Validea’s Trend Following Tool

Trend Following Defined

Before we get into the details, let’s first quickly define what we mean by trend following here at Validea. Trending following is a rules-based, systematic approach that utilizes the trend of an asset (i.e., an index, investment strategy, ETF or stock) to determine if you should be invested in the asset or not. Our trend following system uses a combination of short and longer-term moving averages to govern whether or not we are in a BUY or SELL condition. A trend following approach is trying to accomplish one of two things. In an up market, a trend follower hopes to benefit from the rising trend and seeks to be invested during these periods. In a down market, trend following strategies seek to reduce downside risk by getting out of the market or hedging.

Of course, this sounds easy, right – buy the market when it’s going up and get out when it’s going downif only things were that simple.

Avoiding The Worst

When trend following is applied to investing in the stock market, there are two big advantages I see.

The first is that trend following can help protect capital in major bear markets and declines. We track the maximum loss on over 55 asset classes, investing styles/sizes and our guru-based strategies and the max loss with trend following is lower on 90% of these vs. the max loss if an investor would have just bought and hold. The table below highlights those assets where trend following would have done very well in helping protect capital from losses that would be difficult to tolerate for the majority of investors. For example, riding the NASDAQ 100 down nearly 83% during the dot com bust is next to impossible for most, and being able to avoid the 77% max loss in commodities, which go through boom-and-bust cycles, would have been nice as well. Assets that tend to see these types of massive declines are good candidates for trend following systems.

Asset Class (Index, Guru Model, Sector ETF)Start DateMax Loss (with Trend)Max Loss (Buy & Hold)
Nasdaq 10010/2/198545.10%82.90%
MSCI EAFE8/28/200135.20%61.00%
Acquirer’s Multiple Investor (CARLISLE)12/29/200840.50%70.90%
Quantitative Momentum Investor (GRAY)1/3/200645.40%70.60%

Getting Out and Back In

The second advantage is trend following is that, by its nature, it is systematic if deployed correctly. Each buy and sell decision is based on a set of rules and those rules take the emotion, subjectively and biases out of the decision making process. For most investors that is good (especially during market declines when investors have a tendency to overreact).

With trend following there are rules with respect to when to get out and also when to get back in – there are really two decisions not just one – and both of those are important even if one isn’t correct.

Let’s look at the example below using the S&P 500 over the past six years (full history here) with our trend following model. If you remember back to the Spring of 2020 during the depths of COVID pandemic, the market fell tremendously over about a month but in late March stocks began to stabilize and move higher.

Signal DateNew SignalS&P 500 CloseWin/Loss% Change
4/14/2022SELL4,392.59 TBD

So Good So Far – Not So Fast

But like most things in the market, there is always a trade-off and nothing is as easy as it seems. Implementing trend following on stocks is no different and the long-term data on the market helps us understand why trend following would be difficult for most investors.

First, let’s look at the facts per this Capital Group article. The chart below uses historical data on the S&P 500 and it shows most 10% to 15% corrections, which happen over a four-to-nine-month period don’t turn into full fledged bear markets, but in my experience most trend following models would be moving out of stocks during these periods. As a result, trend following gets the signals wrong more often than it gets them right.

DeclineFrequencyAvg. # of Days
5% or more3 times a year46
10% or moreOnce a year117
15% or moreOnce every 3.5 years275
20% or moreOnce about every 6 years425 days

Source: Correction or bear? 6 charts that explain market declines

Taking The Stairs Up & The Elevator Down

The chart below, sourced from the same article, highlights another related challenge of trend following – bull markets tend to be longer lasting with corrections sprinkled into all of them. When you look at the bull market regimes below, you will see major advances in each bull market, but with multiple corrections in each of them. What’s more, bear markets tend to be much shorter than bull markets with the average bull market lasting close to six years and the average bear market a little more than a year – and because some of the best returns come early on in bull markets, trend following can be out of the market during those periods when stocks are producing some of the very best returns as the market moves from bear to bull regime,

The dynamics pointed out above is one reason why trend following signals don’t always work – in fact in some cases they don’t work the majority of the time. If you think back to the period since 2008/2009, every pullback in the market since then (2011, 2015, late 2018 and early 2020) didn’t end up turning into a major bear market. Trend following would have detracted from buy and hold during this period. Even the most zealous trend follower would have had their will tested over a 13+ year period where trend following showed its weaknesses, but at some point, those who use trend following, and remained disciplined to this approach, will likely be rewarded with much lower losses and will feel far less pain and fear. We may be at the start of one of those periods, or this may be another market head fake – only time will tell. 

Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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