Trend System on Other Assets

This post is a continuation of a series on the multi-model trend system which I have developed. In the past weeks we looked at different applications of my trend model. First, I looked at several backtests on the S&P 500. I then applied the exact same trend system on other major equity indices: the Nikkei 225, NASDAQ Composite, and CAC 40.

The following links cover these backtests and some other information about the system I developed.

Long and Short Trend Systems

Long/Flat Equity Trend Systems

Long Trend System on Other Equity Indices

Reminding readers... I have developed two trend systems which have many similarities in their structure. The major difference is the time examined. The shorter duration system uses a lookback period of trends that are identified at two weeks through three months. The longer duration system sees trends forming at three months through twelve months. I've called them the short-term trend system and long-term trend system.

In this post I will apply the exact same systems on other assets. This includes currencies (EUR/USD and JPY/USD), interest rates (10 Year Treasury Yield), and alternative commodities (gold and Bitcoin). The currencies and interest rates will be using the long-term trend strategy that goes both long and short the asset, betting on either side of the trade based on the trend.

Gold will be using the long-term system in a long/flat format (betting with the trend fully or partially, or being in cash). Since Bitcoin is a newer asset that is highly volatile and difficult to short, I modeled it long/flat with the short-term trend system.

Note: All data is calculated in nominal terms and is not adjusted for local interest rates or inflation. The objective is to demonstrate the behaviour of my trend system across a range of markets. These are simulated results.

Euro/U.S. Dollar Currency Pair

Since the Euro was created as the new pan-European currency it has become the dominant alternative currency to the U.S. dollar. It is also the biggest currency pair trade with a massive number of futures contracts trading hands each day.

The EUR/USD futures contract is a great place to start for people aspiring to be currency traders. One contract controls delivery of 125,000 Euros. This contract requires a margin (deposit) of just $2,000 to hold.

Understand and trade based on the contract value, not the margin requirement! As you can see, the leverage factor is enormous.

The following charts backtest my long-term trend system using absolutely no leverage. This simulates the underlying return of the strategy. Most traders would use some leverage in practice.

Total Performance (Growth of $100)

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Quandl.com.
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If an investor were to buy 100 Euros in 2000 when this backtest started, they would have paid about $102. Today it would be worth about $112, translating to an approximate 10 percent gain to the investor over the backtest period.

With my trend system, that same $100 would have grown to be worth about $168. That implies a gain 5x larger than just holding the Euro.

The Euro/U.S. Dollar is a very stable currency pair to trade and a great place for investors to start with currency trading. The largest drawdown in my trend system was about 18 percent. Many traders can comfortably use some leverage in this asset to increase their exposure on the trade.

Japanese Yen/U.S. Dollar Currency Pair

The second largest currency pair trade is the Japanese yen against the U.S. dollar. As with the EUR/USD contract, this is a major futures contract that trades over 100,000 contracts each day.

A single contract controls delivery of 12.5 million yen worth approximately $115,000 at current rates. The margin requirement for the contract is just $1,800.

The following backtest and charts use no leverage to simulate the underlying return of the strategy. It is a long/short trading strategy as it is extremely easy to short currencies and futures contracts.

Total Performance (Growth of $100)

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Quandl.com.
Right-click to expand image.

Futures contracts on the JPY/USD currency trade have existed for a long time. My data goes back to 1977 and covers a range of market conditions for the Japanese and U.S. economy. If an investor were to buy $100 worth of yen in 1977, that would have grown to be worth about $240 today. That's a 140 percent gain.

With my trading system, $100 would have grown to nearly $600 in that same time period.

As with the Euro, the yen is a pretty stable currency in general. However, we do see quite large moves from time to time. Drawdowns with my system peaked at 36 percent. We also see a relatively long period of declining returns from the late-1990s to 2011. Since then new highs were made with the system.

Looking at the 3-year annualized rolling returns, we can see the sharp difference between the return characteristics of currencies compared with stocks when applying a momentum strategy to both markets. Returns on the yen do not see significant negative returns when smoothed, but the declines are grouped together into several years of poor performance.

Interest Rate on 10 Year Treasury

Trading interest rates can offer investors a return stream that is very unique, different from bond investing, but yet relatively stable. The interest rate often take the inverse of bond returns in the shorter term. When interest rates go up, bond values drop; when interest rates drop, bonds jump up.

Interest rates can be trading via futures contracts. I would not recommend short-selling a bond ETF. Futures allow you to trade more closely in line with interest rates in a liquid market. A single contract controls $100,000 of Treasury notes.

As with currency pairs, with futures it is easy to go long or short the contract (buy or sell) at a very low margin requirement of just $1,050 on the 10-Year Note Contract.

Total Performance (Growth of $100)

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Yields on 10 Year Treasuries often move slow; a long-term trend system works particularly well. If an investor put $100 into this strategy in 1963, it would have grown at a pretty steady rate to nearly $4,000 today.

Drawdowns reached about 40 percent, but in the backtest the recoveries were very quick compared with many other assets we looked at. The drawdowns seem to have gotten bigger in recent years. This may be indicative of a shift in the market characteristics.

Gold

In this backtest I used my long-term trend strategy on gold, buying and selling in U.S. dollars. Gold has long been a favourite alternative asset for many investors. I would describe gold as a sort of crisis asset. It often does well when many other markets do not. Being the classic "hard asset", it is particularly a good asset to hold when trust in currencies fades.

Although it isn't necessarily difficult to short-sell commodities via futures contracts, I don't think it makes as much sense as short-selling currency pairs or interest rates. With commodities short-sellers have the headwinds of a long-term upwards bias due to inflation and depletion of resources.

Gold can be purchased with ETFs such as GLD or IAU and with futures contracts. A single gold contract controls delivery of 100 ounces of gold. It is a highly liquid contract with roughly 270,000 contracts traded daily.

In this backtest I compared my long-term trend strategy against simply buying gold and holding it throughout the period.

Total Performance

Credit: TheRichMoose.com, Quandl.com, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Quandl.com, FRED-Federal Reserve St. Louis.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Quandl.com, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Many investors see gold as a safe asset that is linked to inflation and should always go up. This isn't the case. Since the U.S. dollar was delinked from gold, the yellow metal has had periods of high returns and long periods of negative returns.

Even during the inflation period of the early-1980s, gold actually dropped in price. If you bought gold in 1979, you didn't see a profit until 2008. Instead of being safe, gold took a massive 70 percent drawdown over 30 years.

Using a trend system, we substantially reduced the severity of the drawdowns. We also saw nice gains when gold moved up. The overall return for the trend system was only about 4x higher, the returns were more stable and allowed long periods where an investor could do other things with their money (held in cash in this scenario).

Bitcoin

Bitcoin is a newer asset that still carries many questions. While certainly interesting, its viability as a usable currency is not there in my view. I also have a hard time seeing Bitcoin as a safe asset with gold characteristics.

Since Bitcoin was spawned, many other cryptocurrencies with improved technology and capabilities have come to the market. One day we could see some type of decentralized cryptocurrency used in daily life. We are definitely some time away from that yet.

Right now I would say that Bitcoin in simply another asset to speculate with. It is not a buy-and-hold item. It is not where anyone should put a substantial amount of their wealth. There are issues with security, storage, scalability, among other problems.

Thankfully it is getting better. There is an increasingly popular Bitcoin ETN on the market trading with the ticker GBTC. This makes Bitcoin a bit more accessible and possibly a bit more secure to hold, albeit with regulated third-party risk.

Bitcoin is a new, volatile asset. It is also not easy to short-sell. For this reason I applied my short-term trend strategy in a long/flat format, compared to simply buying and holding a single Bitcoin.

Total Performance

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Annualized Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance.
Right-click to expand image.

Bitcoin is a truly crazy asset. Since 2010, it has seen numerous 90 percent drawdowns. Bitcoin also saw enormous annualized returns. As the market is maturing, the swings are getting less severe.

My trend system cut drawdowns on Bitcoin nearly in half and, as usual, nicely smoothed returns for an otherwise rough asset. By dancing out of the worst of the drawdowns, the trend system would have returned over 3x more to the investor.

For those interested where Bitcoin fits into the portfolio, this article recommended investors have no more than about 2 percent of their portfolio in Bitcoin. Many investors should probably have none.

Is Bitcoin in the Optimal Portfolio? - Of Dollars and Data

Personally I believe you should risk no more money in cryptocurrencies than in any other asset. The rule of thumb is to risk about 1 to 3 percent of your assets per trade, depending on your level of aggression. Since Bitcoin and cryptocurrencies have huge drops in value and could realistically become worthless, that means you should have a maximum of 1 - 3 percent of your assets in cryptocurrencies.

I currently don't hold any cryptocurrency but I am watching some of the developments on the newer third-generation crypto projects with interest.

Summary

A good investment system is not limited to a single market. It is applicable and effective across a range of markets experiencing very different market conditions.

I will continue to update readers on the momentum factors of the markets I am personally invested in. In the meantime, I will be working on my systems trying to improve the systems and make them easier to invest with for my own purposes.

I'm interested in hearing your questions about investing or personal finance and ideas for blog posts. Please leave a comment or send me an email at: richmooseblog @ gmail . com.

Comments & Questions

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Long Trend System on Other Equity Indices

Plenty of academic research, fund managers, and individual investors have demonstrated that investing with long duration trends is highly effective when applied on broad equity indices as well as other assets.

Generally, academic research finds support is strongest for investing based on trends that are identified at three months to twelve months in duration. But this is far from exclusive. There are plenty of examples of successful investors who follow much shorter trends; however, careful risk management and trade management becomes exponentially more important as duration shrinks.

I have examined two categories of complex trend systems: short duration (approximately two weeks to three months) and long duration (approximately three months to twelve months). I also looked at long/short applications of the trend system (betting with the upside when the trend was up, betting with the downside when the trend was down) and long/flat applications (betting with the upside, or being partially or completely in cash when the trend is down).

I developed what could be considered complex trend systems. They do not follow a single measure of trend. Instead, they examine trend direction using time-series momentum, price-minus-moving average, moving average crossover, and moving average direction. Combined, these four methods of identifying trends are calculated dozens of times across of range of time periods and carefully weighted to provide an exposure factor between -10 and +10, or between 0 and +10.

Long and Short Trend Systems

Long/Flat Equity Trend Systems

A Perfect Trading System is Futile

In the posts I linked above I applied both systems against the S&P 500 index. In doing this, I noticed the S&P 500 has gone through a shift in its nature. Before the 1980s shorter duration trends were very effective. After the 1980s longer duration trends performed substantially better. Markets shift in their own nature over time.

One market is also likely to behave differently from another market. For this reason I think it could be advantageous to diversify across trend durations. A good way to do this is through a complex system that covers a range of market conditions without constant tinkering on the overall system.

Trying to develop a system that is historically the best on a single market and doing that for several markets for adequate diversification is futile and maybe even reckless. A perfect trading system via a backtest is an assumption that the market will remain constant. Markets are not constant and do not behave according to defined parameters (such as a chemical element); instead, they are organic, multi-faceted, and a product of an ever-shifting environment and human behaviour.

Acknowledging this reality of markets, my trend system is an attempt to design an appropriate and diversified method of investing with the trend that works across numerous markets and widely varying market conditions over time. It is adaptable and responds adequately to organic conditions by scaling into and out of trends based on the strength of the trend.

Focusing on the long duration trend system I developed, we will examine the performance of my system on several major international indices: the Nikkei 225, the NASDAQ Composite, and the CAC 40. While limited by good data, I am attempting to choose indices which have unique performance characteristics.

Note: All data is calculated in nominal terms without dividends and is not adjusted for currency exchange rates, inflation, or local interest rates. The objective is to demonstrate the behaviour of my trend system across a range of markets.

Nikkei 225

The Nikkei 225 is Japan's most popular index and I can obtain daily data going back to 1965. As many investors know, the Nikkei climbed to insane heights over several decades, peaking in 1989. Today, the Nikkei is sitting at barely more than half of its peak value as the Japanese stock market and economy contracted and then stagnated for nearly three decades.

Given the volatile nature of the Nikkei in earlier years and the lacklustre performance over several decades, the Nikkei can provide a great real-life stress test on any investing method. If a well-grounded investing system works on both the Nikkei and the S&P 500, it should work almost anywhere.

Total Performance

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Viewing the above three charts, we can see the some important performance characteristics of my multi-model trend system when applied to the Nikkei 225 index. Over the 53 year period the Nikkei price increased at a compounded annual rate of 5 percent. During the same period my trend system would have returned more than 8.25 percent annually.

As should be expected from any good trend system, the drawdowns of my system applied on the Nikkei 225 are much lower than the index drawdowns. While the Nikkei declined approximately 80 percent from peak valuations several times, my trend system had a maximum drawdown of just 30 percent (in 2012). The other major drawdowns of my trend system were held to approximately 15 percent—very tolerable for almost any investor.

The final chart, showing annualized 3-year rolling returns for the Nikkei and my trend system, paints another very compelling picture for trend investing. My trend system is much more stable and had much shorter periods of negative averaged returns. During periods of very positive returns the trend system very closely tracked the index; during periods of negative returns the trend system tracked well above the index.

Overall, the trend system investor would have finished nearly five times wealthier than an index buy-and-hold investor. During the backtest period, they would have experienced much smaller drawdowns and spend more time in positive return territory. The risk-adjusted returns are incomparable in the advantage of the trend investor.

NASDAQ Composite

The NASDAQ Composite index is possibly the U.S. stock market's most volatile major index. Filled with growth stocks, the index generated a 16x gain in the 1990s followed by an 80 percent drawdown the next two years. After a short gain, it was followed by another 55 percent drawdown in 2008.

Recently the NASDAQ has made a great gain and is at all-time highs again. The NASDAQ is another market that provides a great example of testing an investing model applied on a more volatile market.

Total Performance

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

The three charts above showing various metrics of my long duration trend system applied on the NASDAQ Composite index again demonstrates the advantages of trend systems on markets. While the NASDAQ clearly behaves different from the S&P 500 or Nikkei 225, a complex trend system is equally effective at managing risk and generating great returns.

Overall, in my backtest the NASDAQ generated a 9 percent compounded annual return. During the same period the trend application returned approximately 11.4 percent compounded annually. Investing wisely with the trend would have left the investor nearly three times wealthier over four decades.

The drawdowns are also much lower. The maximum drawdown was reduced from nearly 80 percent to just under 40 percent with the trend system. Most of the other larger drawdown periods were also half the severity with just two breaking briefly below a 20 percent decline.

The annualized 3-year rolling returns show improved stability, smaller drawdowns, and just a few brief windows of negative returns over a three year period for the trend system investor. While even the best trend systems will underperform the index in good times, that difference is quickly reversed when the index corrects to the downside.

CAC 40

The CAC 40 is France's most popular index and my data goes back to 1990. The CAC 40 is characteristic of a slower growing index and a mature market that has experienced economic difficulty. Price returns—at 3.3 percent compounded annually over the past 29 years—are not very high. Since 2000 the index price has returned -1.15 percent annually.

The CAC 40 can provide investors with a look at how an investing model can perform on a market with a long range-bound period.

Total Performance

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

Drawdowns

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

3-Year Rolling Returns

Credit: TheRichMoose.com, Yahoo Finance, FRED-Federal Reserve St. Louis.
Right-click to expand image.

The three charts above show a unique, and still highly beneficial, application of my long-term trend system on a stagnant market. The time period examined in this backtest for the CAC 40 is noticeably shorter than the previous indices.

While lagging the underlying CAC 40 in the beginning of the backtest period (when the CAC 40 was performing very well), the trend system soon overtook the index when trouble started. Performance for my trend system is positive after 2000—growing at 1.65 percent annually. This is compared to a negative annualized return for the index. Since 2007, even the trend system has been quite stagnant, with returns oscillating in a relatively tight range.

As usual, the drawdowns for the trend system are much lower than the underlying index. The CAC 40 itself has declined as much as 60 percent several times in the past twenty years while the trend system held drawdowns to approximately 25 percent. The CAC 40 has been in a drawdown since 2000—nearly 20 years—but the trend system made new highs in 2010.

The annualized 3-year rolling return chart once again demonstrate better characteristics for my trend system. The range of returns is tighter, the system is stable, and periods of negative returns are generally shorter less severe.

Summary

My complex trend system, without any changes made from one application to the next, is highly effective across a range of markets. This speaks to its adaptability and mitigation of market risk, timing risk, and specification risk. The benefits are even more pronounced when used in a properly constructed portfolio with several markets that behave differently.

Trend investing may not always provide the highest absolute returns in any single period and certainly should underperform in the upwards half-cycle of any market. But when appropriate designed, a trend investing system can be relied on to provide excellent risk-adjusted returns across full market cycles. We see smaller drawdowns, more stable performance across time periods, and carefully calculated exposure to risk that is continually updated and monitored.

In the next post discussing my multi-model trend system I will demonstrate the use of this exact same system on completely different markets: currency pairs. Currencies are great markets for investing both with the upside and downside of a specific currency pair. They are also demonstrated to provide returns which are uncorrelated with equities, making them a good candidate for diversification in your portfolio.

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.