Improving Trend Following PerformanceDavid Schassler, Portfolio Manager and Head of Portfolio and Quantitative Investment Solutions, VanEckMay 28, 2020
We have recently experienced the fastest major market decline, from peak-to-trough, in the history of the U.S. stock market. Historically, the natural bias of the U.S. stock market has been upwards. Downward trending prices are a big warning sign that something is amiss and are typically a good signal to get defensive.
The Ned Davis Research CMG US Large Cap Long/Flat Index is designed to protect against major market corrections by changing its allocations from being fully invested in securities that track the S&P 500® Index to a safe portfolio of short duration U.S. Treasury bills. It does this primarily by measuring the stock market’s breadth, by comparing an average of near-term prices to an average of long-term prices to determine if the market is trending upwards or downwards.
Rapid Corrections Are More Often a Time to Buy
During the course of the 2020 correction, the Long/Flat Index remained fully invested. Why did the model remain invested in the worst correction ever?
The model did not move to cash, because in addition to measuring breadth, the model also looks for buying opportunities. More specifically, rapid corrections in stock prices are typically a reason to buy, not sell. Hence the saying, “buy the dip.” The underlying index incorporates a mean-reversion indicator which boosts the model’s Breadth Score during extreme selloffs (effectively triggering a buy signal). Historically, when mean-reversion indicators trigger a buy signal, the market has outperformed over the next month.
To prove this point, we tested the idea on the S&P 500® Index going all the way back to January 31, 1928. In the one-month period following these extreme near-term price declines, the average annualized return for the S&P 500® Index was 11.64% versus the average annualized return in other periods of 7.94%.1
S&P 500 Average Annualized 1-Year Returns
The Limitations of Pure Trend-Following
To better understand what happened, we must contextualize the 2020 drawdown. As everyone knows, the trigger for the correction was a global health pandemic that most were not expecting, followed by a government-forced shutdown of the economy. The chart below shows each major U.S. historical market drawdown. As you can see, the current bear market is second to none in terms of its swift severity.
A Market Like No Other: Historical Drawdowns
Source: FactSet. Data as of May 22, 2020.
The S&P 500® Index peaked at 3,386 on February 19 and then fell off a cliff. It eventually bottomed at 2,237 on March 23, posting a peak-to-trough drawdown of approximately 34%! Most attempts to get defensive based on trend following alone would have likely been too late and resulted in selling near the bottom.
Why This Correction Was Different
The Global Financial Crisis (GFC) was our last major correction and it took a typical route “south.” In 2007, financial institutions with exposure to the housing market began to go bankrupt as housing prices fell, shedding light on just how much leverage was in the system. In the summer of 2007, the S&P 500 reacted with increased volatility and falling prices as the market began digesting the seriousness of the situation.
The popularly watched 50 x 200-day moving average (MA), or what is commonly referred to as the “death-cross,” performed well during the GFC. When the 50-day MA falls below the 200-day MA, it is a signal that prices are trending downward, and it is probably a good time to start thinking about playing defense. This signal got defensive in December 2007, well in advance of the most severe part of the correction.
Defensive Signal in 2007
This time around, in 2020, there was just no time in which to react. We went from a 3.5% unemployment rate and all-time highs in the stock market to the highest unemployment levels since the Great Depression and the fastest major stock market correction ever in just over one month.
Compared to the results of 2007, the 50 x 200 day MA strategy did not hold up. Unsurprisingly, as the chart below shows, it would have signaled “sell” late into March and near the market bottom.
No Chance to React in 2020
Sometimes It’s Better to Do Nothing at All
We believe traditional trend following had no realistic chance of getting defensive early into the recent correction. Given the market’s upward bias and tendency for strong rebounds after major market sell-offs, we think sometimes it’s better to wait than react. One potential solution is to evaluate trends over multiple time periods and pair trend signals with a mean reversion indicator to help limit whipsaws or selling at the bottom.
VanEck Vectors® Long/Flat Trend ETF (LFEQ®) seeks to track the Ned Davis Research CMG US Large Cap Long/Flat Index. The underlying methodology measures the stock market’s breadth, by comparing an average of near-term prices to an average of long-term prices to determine if the market is trending either upwards or downwards. Additionally, the index also incorporates mean-reversion indicators to help to protect from selling at or near the bottom.2 We believe that such a thoughtfully-constructed, systematic approach to equity investing may allow investors to participate in the upside, while potentially side-stepping destructive bear markets.
1 Extreme near-term sell-offs are measured using z scores of current prices relative to 20-day price averages and a -2 standard deviation event or greater.
2 In this blog post we have used simplified examples to easily communicate the general methodology of LFEQ. The actual methodology of LFEQ, while very similar to what was described here, uses more advanced techniques to measure market price activity.
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