Trend-Following-A Strategy You Can Stick With

Last week, I went into a transparent, educational deep-dive on how to identify whether the market is in an uptrend or a downtrend.  In this 3rd installment of NERDvember, I’m going to show you what the results of a trend-following strategy look like, in real dollars, over the long-term, in both good and bad markets.  If you want to catch the first article, Click Here.

 

Before we go any further, please understand that whenever I show performance charts in these articles or any sort of back-tests, they are conceptual in nature.  In other words, the performance results below do not include individual investment selection, nor do the results include any sort of fixed income or bond positions.  I’ve done this on purpose (using only the S&P500 and cash/money market) in order to create an authentic examination of trend-following strategies and their effectiveness.

 

For example, adding bonds (instead of money market funds) at times when the market was in crash-mode will skew the results in the strategies’ favor.  While this might sound okay on the surface, it’s crucial to realize that, over the last 25+ years, bonds have been in a historically significant bull (up) market, which is a direct result of the fact that interest rates have been falling since the 1980’s.  And since interest rates and bond prices are inversely correlated, we cannot assume that the next 25 years will result in such positive performance from bonds, but I digress.

 

The bottom line in my disclosing this information is to share that a “back-test” is part of a trading/investment system test that is simply meant to discover an understanding of whether an investment strategy works or not… and if it does work, how well.

 

In our patented Defense First® trend-following strategy, we use two, very different trend-following indicators in order to determine whether the market is in an uptrend or a downtrend.  When one of these indicators goes off, stop-losses are tightened to high-risk-environment levels and “risky” investments are sold as their individual trends break down.  Typically, as the market’s trend breaks down, individual sectors, sub-sectors, industry groups, and stocks all break down on their own, so it becomes pretty obvious that there is potentially more trouble on the horizon for the domestic and/or global markets, as a whole.

 

The back-tests illustrated in this article have been tested using one of these two triggers, and for any strategy to be robust, it should be tested over a timeframe that includes an uptrend, a market crash, as well as a neutral market (i.e. – a trendless environment).  While every strategy has its imperfections, testing in this manner provides evidence that the system will work in all market conditions, over the long-term (which is defined as 10-20 years or more).

 

This first test (below) is over 20+ years and starts just before the 2000-02 dot-com crash.  The red line is the S&P500 if you were to buy and hold it throughout the entire period.  The blue mountain chart is the result of the trend-following strategy, where the portfolio is moved to cash/money market at each of the times indicated.  During longer periods of market turmoil, the blue chart flatlines, making these crash-periods more obvious.

 

 

As you can see, there are times when the strategy works wonderfully (2000-02 and 2007-09), but there are times when its imperfect, such as 2010, 2011, 2015, 2016, and 2018.  I say “imperfect” because the strategy caused the portfolio to be moved to cash, but the market never actually crashed, which caused a short-term lag in performance.

 

Of course, due to the protection provided by the strategy during the two, catastrophic crashes over this 20+ year timeframe, those imperfections were dwarfed by the immense benefit of protecting the retirement portfolio during bear markets and recessions.

 

Now, the first test provides compelling evidence that trend following worked over the last 20+ years, but it’s important to understand that the test began just before a huge market crash.  In order for the system to be truly tested, it would only make sense to test the start of the strategy throughout a strong bull market.

 

So, in the next test, below, we start the ball rolling 25+ years ago, so that it includes the historic bull market of the 1990’s.  As you can clearly see, the strategy gets the portfolio out of stocks and into cash, but the market doesn’t crash.  Hence, buying and holding the S&P500 ends up out-performing the trend-following strategy for a full 8+ years!  That is, until the first crash arrives, after which, the trend-following strategy quickly catches up and begins to out-perform in the long-run.

 

 

Keep in mind, neither of the two tests above include any portfolio withdrawals, but why is this important?

 

Let’s say you have the desire to quit working someday, but your social security, pension, and/or other fixed income from other sources (i.e. – real estate, etc.) is not enough to pay your basic living expenses, vacations, and so on.  As a result, you would likely begin taking systematic, monthly withdrawals from your portfolio at some point in retirement in order to supplement this fixed income (and perhaps additional withdrawals throughout the year for vacations).

 

The above-tested strategies don’t account for such withdrawals, but if they did, it would be even more important to avoid market crashes, because when you take money out of your portfolio when it’s down -40-50% in value, all of a sudden you’ve “lost” even more money when combining the market loss + income supplementation.  In other words, if you bought and held your investment portfolio through a crash, all while taking withdrawals, then you’d be down even more than you would, simply being exposed to the full brunt of the crash, on its own.

 

Here is a hypothetical example of what happens when you start with one million dollars, withdraw 5% (or $50,000) per year to supplement your income, but the market goes down -10% the first year, then -37.5% the next year.  Notice how the withdrawal rate changes from 5%/year to 10%/year due to the loss of assets thru both market loss and withdrawals?

 

 

This means you now need a 10%/year growth rate, just to break-even… or you need to reduce the amount of money you withdraw from your portfolio, thus reducing your standard of living.

 

In closing, I want to circle back to the concept of transparency and full disclosure by saying that there is no perfect investment strategy.

For the first seven years of my career, I managed money using what most firms implement, which is a strategic, buy & hold, diversification method of investment and risk management.  Since 2008, I’ve implemented technical analysis and trend-following because I believe that the long-term results will be less-risky, and more advantageous to our clients’ retirement portfolios over the long-term.

 

Why do I think trend-following is better than buy & hold?  The answer is simple – compare the imperfections of each strategy and choose which imperfection you’d prefer:

 

Buy & Hold Pros:

  • Works well when the stock market goes up,
  • Avoids the “false tornado sirens” and whipsaws that exist in a trend-following strategy.

 

Buy & Hold Cons:

  • Does not work well when the market crashes, and
  • The approximate worst loss one can expect during a crash, even in a diversified, balanced portfolio is easily in the -30-40% range.

 

Trend-Following Pros:

  • Works well when the stock market goes up, and
  • Works well when the market crashes.

 

Trend-Following Cons:

  • False “tornado sirens” can take place, causing underperformance during periods of whipsaws and quick turn-arounds in the market (such as times like 1998, 2010, 2011, 2015, 2016, and 2018)
  • The approximate worst loss one can expect during a crash, in a diversified, balanced portfolio is in the 5-20% range, depending on portfolio allocation.
  • Important note: The worst loss in the above-mentioned back-tests going back 25 years occurred in 1998 and 2015-16, to the tune of -16.1%, invested 100% in the S&P500 stock index.

 

When I made the decision 11+ years ago to manage our clients’ retirement dollars using trend-following, I did so with risk management in mind.  In other words, I started with “What’s the worst loss I’d want to accept in our most aggressive clients’ portfolios, long-term?”

 

So, understanding that implementing a Trend-Following strategy is imperfect, just like strategic Buy & Hold is imperfect, it comes down to “which imperfect would you like?”  Or asked another way, “Which strategy would you stick with, when faced with ‘the worst imperfection’ of said strategy?”  After all, if you have a retirement plan, but you don’t stick with the investment strategy, what good is the plan?!

 

For me, I’d rather avoid losses, first, since when you make a profit, you need to keep that profit, too… especially when you’re retired, or plan on using your hard-earned savings to supplement your retirement income someday.

 

Till next time…

Adam

Categories: Adam Koos, CFP®, CMT®, Market Commentary

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