Long/Flat Equity Trend Systems

In my blog post last week I dove into complex multi-model trend applications on the S&P 500. In that post, I modeled out trend systems that are either long or short—betting either with the uptrend or the downtrend. You can read that post by clicking the link:

Long and Short Trend Systems

In that post I largely found that going short—or betting with the downside—is a futile effort for many equity index investors. This is even the case when the higher costs of short-selling are excluded. Today, of course, we have lower cost options such as E-mini futures contracts and inverse index ETFs.

Successfully betting with the downside on equity markets is incredibly difficult. I believe a large part of this difficulty stems from the increased volatility the equity markets experience during downtrending periods. Prices can move sharply one way or another, quickly shifting trend directions and eroding the possibility of compounding gains that can be crystalized for the investor.

This is not to say that gains cannot be made betting with the downtrend. When rising markets slowly rollover and then gain momentum on the downside, long/short trading systems can see enormous gains in a very short time. However, these systems fail to hold onto most of the gains as reversals are often sharp and unpredictable. Timing the transition from being short the market to going long the market is an epic challenge.

In contrast, uptrending periods in equities tend to be much less volatile. A buyer can often hold the market for a long time and see beautiful compounding gains during these holding periods. Strategic re-balancing strategies allow investors to hold onto the gains.

Following Uptrends in Equities

The dichotomy of trend characteristics within equity indices provides investors with an opportunity to make the best of the trends they can more easily profit from—the uptrending side of the market.

Since uptrending markets are generally less volatile, we can buy the market as it enters an uptrend based on the trend systems’ definition or identification of an uptrend. We can often stay in the market for a long time, holding the market until the frequently-observed slow rollover in the trend occurs. Then we exit. Of course, this isn’t always the case. October 1987 is the classic reminder that uptrends don’t always have gentle transitions.

In the following backtests we identify short-term trends as seen from 2.5 weeks to 3 months of price movement. Long-term trends are identified from 3 months to 12 months of price movement. As a long/flat trend model, the factor scale goes from 0 to +10 in both trend models. When the factor is at 0 the investor will be fully in Treasury bills; when the factor is at +10 the investor will be fully invested in the S&P 500.

Long/Flat Short-term Trend Model

Short-term trends, as one would expect, involves a lot of monitoring of the trends for signal changes. There are relatively long periods of holding the same position without any changes; however, they are often limited to a few months in duration.

In this backtest I used my short-term trend model on the S&P 500 price going back to 1950. It does not include any distributions.

Credit: TheRichMoose.com, Standard & Poors, FRED-Federal Reserve St. Louis

The second chart in this section shows the drawdowns of my short-term trend model. The drawdowns are very muted into the 1980s. Entering the 1990s the drawdowns are noticeably larger. Some of this effect may coincide with the shift in the effectiveness of short-term trends after 1987, which I previously observed in my post on long/short models.

Despite the increase in drawdowns beginning in the 1990s, the overall drawdowns of this system are still much lower than the underlying index. For example, the S&P 500 index saw a price decline in excess of 55 percent in the 2007-2009 period.

Credit: TheRichMoose.com, Standard & Poors, FRED-Federal Reserve St. Louis

Long/Flat Long-term Trend Model

The long-term trend model in this section measures trends exceeding 3 months in duration. As one would expect, the holding periods without any change are much longer—many exceed one year in duration.

As in my short-term trend model, this backtest is applied to the S&P 500 index price. Distributions are not included.

Credit: TheRichMoose.com, Standard & Poors, FRED-Federal Reserve St. Louis

Well into the 1960s my long-term trend model was performing very comparably to the S&P 500 (though with smaller drawdowns). The trend model began pulling away from the underlying index beginning with the 1969 market correction. The performance during the 1973-1974 downtrend period further solidified the gains of my long-term trend model.

While my long-term trend model performs very favorably compared to the underling index during larger downtrending periods, this trend model still does experience relatively large drawdowns. The following chart shows the drawdowns from 1951 to 2018.

Credit: TheRichMoose.com, Standard & Poors, FRED-Federal Reserve St. Louis

The deepest drawdown period with my long-term trend model occurred in the October 1987 crash. My model caught nearly the full brunt of the sharp decline. In the other major market drawdowns—2000-2003 and 2007-2009—the long-term trend model held drawdowns at 20 percent. This is a very impressive performance compared with the much larger drawdowns of the underlying index.

Short-term vs. Long-term Trend Models

Choosing between the short-term trend model or the long-term trend model is not easy. During the nearly seven decade backtest period, both models have generated nearly the same overall return and have clearly outperformed the S&P 500 index. My long-term trend model is easier to manage and does a great job of reducing drawdowns while achieving index-beating returns. With long holding periods it is probably a better option for most self-directed investors. It would be more tax-friendly as well in regular trading accounts.

However, my short-term model also is impressive. It does a better job getting out of bad situations quickly. We saw this clearly in 1987. The short-term model had completely exited the market by October 9, two weeks before the October 19 crash. Aside from trading much more frequently, one of the drawbacks of my short-term system is the larger overall drawdowns in the big market downtrends. This is because the model re-enters the market during reversals, losing some money before exiting back to Treasury bills.

The following chart shows the total performance of both my short-term and long-term trend models applied on the S&P 500.

Credit: TheRichMoose.com, Standard & Poors, FRED-Federal Reserve St. Louis

My short-term trend model handily outperforms my long-term trend model at the beginning of the backtest period. This performance gap begins to shrink after 1987. In recent years my long-term model has significantly outperformed my short-term model (though since 2000 returns have been more subdued for both).

A chart tracking the annualized 3-year rolling returns of each trend model shows this performance difference much more clearly. The darkened area represents the difference between the rolling returns of my long-term trend model compared to my short-term trend model. As explained, it shows the outsized returns of my short-term model at the beginning of the backtest period. The long-term model begins to outperform in the latter half of the backtest.

Credit: TheRichMoose.com, Standard & Poors, FRED-Federal Reserve St. Louis

Summary

Examining the models, my long-term trend model and short-term trend model both show great returns that have beat the underlying S&P 500 index. They both demonstrate excess returns over full market cycles and have greatly reduced drawdowns. This translates to superior reward/risk ratios.

In recent decades, the advantage in overall performance seems to have shifted somewhat in favor of my long-term trend model. This was not always true. Until the 1980s my short-term trend model on the S&P 500 was very effective. The logarithmic chart for my short-term trend model shows a very neat staircase effect of large returns followed by mellow periods.

Using a long/flat trend model appears to be much better than a long/short trend model when applied against broad equity indices. The S&P 500 is not the only broad equity index, but it serves as a good marker of equities in general. I have done backtests on a range of other broad market indices which show similar results.

In the coming weeks I will complete a post on my long/flat trend model applied to other large indices in U.S. and foreign markets.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.

Long and Short Trend Systems

Trends in financial instruments are extremely interesting. A certain trend-based model can provide consistent outsized returns in some applications, but when the same model is applied to a different market those outsized returns may vanish quickly. Likewise, similarly constructed trend-based models that vary only in duration of trends can have wildly different results on the same market.

On the one hand this may tempt us to create different trend models for different markets, but on the other we know it's dangerous to data mine results for a backtest. This type of period specific data mining can provide catastrophic results moving forward.

Over the past few weeks I have been looking carefully at complex trend models applied to a range of markets. This includes focusing on shorter-term trend models, longer-term trend models, blended trend models, long/flat applications to trend models, and long/short applications to trend models.

Trend Models on Equity Markets

When I want to do a long backtest on an equity market, I am generally confined to the S&P 500. This is the only market where I can get free daily or weekly data on that extends back to 1950. From there, I can get Nikkei 225 data from 1965, NASDAQ Composite data from 1971, FTSE 100 data from 1984, Russell 2000 data from 1988, and so on.

Unfortunately MSCI and FTSE keep a pretty tight lid on daily data from their more popular international indices: the MSCI EAFE, MSCI Emerging markets, FTSE Developed ex-U.S. and FTSE Emerging markets index.

Aside from being the most popular stock index in the world, this is why we see the S&P 500 being used as the example market in nearly every model published on the internet blogs. This includes my little writing project.

Long/Short Trend Model (Short-term)

Short-term trend following is very profitable in certain time periods. While it can appear highly technical and advanced, or at least difficult for your average self-directed trader to implement, it has become a lot easier with developments like the E-mini futures on major indices.

In this subsection I've simulated a long/short trend model on the S&P 500 (price only) using trends which are shorter in duration. I took more than 80 trend measurements ranging from 2.5 weeks through 3 months. These were derived into a factor ranging from -10 through +10. If the factor was -10 the investor was fully short; if the factor was +10 the investor was fully long.

A trader in the late 1980s who ran a long/short fund on S&P 500 going back to 1950 using a model like the one described above looked like a genius. It generally performed very well from early 1960s, but importantly it got you on the right side of the 1987 crash. Investors with any sense would have poured money into your hands.

Credit: TheRichMoose.com, Standard & Poors

Since 1987 things have not gone that well for this strategy applied to the S&P 500. The nature of the market seems to have changed after 1987 and the exact same model substantially underperformed the S&P 500 as seen below.

Credit: TheRichMoose.com, Standard & Poors

If you look at the poor performing chart more closely, there are moments of apparent brilliance. In September and October 2008, this single system would have returned nearly 40 percent. This is very aligned with the performance seen by some of the short-term trend equity funds at that time (often amplified by leverage).

Long/Short Trend Model (Long-term)

As one might predict, when we move to longer duration trends on the S&P 500 index the backtest becomes more stable. This is mainly because transitions from fully long to fully short occur more slowly.

In this subsection the trend durations used are much longer. Again I took over 80 different measurements of trend that ranged from 3 months through 12 months. I derived these into a factor ranging from -10 through +10. When the factor was -10 the investor was fully short the S&P 500; when the factor was +10 the investor was fully long.

Unlike the short-term trend strategy, this long-term strategy didn't have any long periods of outperformance relative to the index (except the period from 2000 until 2009 using peak-to-trough measurements).

Credit: TheRichMoose.com, Standard & Poors

The brief moments of massively outperforming the index were quite fleeting. This strategy saw a peak 55 percent jump in 1973-1974, a peak 45 percent jump in 2001-2002, and a peak 75 percent jump in 2008. On the surface this looks like amazing downside protection, but these short periods of outperformance were quickly followed by underperformance.

A quick spike up immediately followed by a quick drop is not a desirable or sustainable solution to portfolio construction. It's all but impossible to try ride the climb up only to get out before it drops down.

A rolling return average demonstrates the sharp moves in the long/short model relative to the index quite clearly. It also shows the sustained underperformance compared to the index.

Credit: TheRichMoose.com, Standard & Poors

Short-term vs. Long-term Trend Model

When we compare our short-term trend model to our long-term trend model, we can see a massive divergence and shift in overall market conditions post-1987. The long-term trend model began to outperform and just 10 years later had pulled ahead of the short-term model.

Credit: TheRichMoose.com, Standard & Poors

Summary

Applying complex trend models to an equity index like the S&P 500 can show some clear differences in how markets behave in short trends and longer trends.

We can see a pretty clear shift in how the S&P 500 behaved (and could be traded profitably) prior to 1988 and following this period. Before 1988, a short-term trend system that traded the S&P 500 both long and short was extremely profitable.

Since October 1987, short-term trends applied to the S&P 500 in the same manner would have performed very poorly. I don't have the necessary data to determine if the profitable period between 1960 and 1987 was an anomaly, or if the market shifted in nature after 1987. Either way, a short-term strategy that went long and short the S&P 500 after 1987 never again saw those great returns in any sustainable way.

Long-term long/short trend systems on equity markets can show impressive profits in downtrending markets. But it would be difficult to realize and hold onto those gains when the market reverses course. We saw this play out in 1973-1974, 2002, and 2008.

In future posts I will apply my trend model to long/flat strategies in the S&P 500 and other equity indices. I also hope to do the same with several of the major currency pairs.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.