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

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Trend Investing with Newfound’s U.S. Trend Index

If you are interested in shifting your portfolio towards a trend strategy, but maybe have some hesitation with certain basic trend models or are not sure how to move away from a buy-and-hold portfolio, Newfound Research has recently released a new trend index based on the U.S. stock market that you can track in your account for free.

As any regular reader of this blog knows, I am a fan of investing with the trend. For example, I believe Dual Momentum is a great choice for individual investors who want diversification and risk mitigation but are managing their own account with time and portfolio size constraints. I personally use both Dual Momentum and a slightly more complex trend strategy in my investment portfolio.

There are countless ways to easily measure trends in equity markets. Dual Momentum uses a 12-month lookback strategy. If the measured asset had a positive return above the risk-free rate over the past twelve months, you invest; if not, move to bonds.

If you had applied this 12-month lookback time-series momentum technique to the S&P 500 and monitored just once a month, you would have outperformed the index by about 200 basis points per year over the past five decades. These one-signal models are easy to track and follow and have shown a lot of benefits for investors. They deftly avoid extended market drawdowns, see nice gains in uptrends, and don't introduce the added risk and complexity of short selling (which is extremely difficult to do profitably).

However, one-signal systems are not without their risks and drawbacks. Over the past few months this has been widely discussed in the quantitative finance world in relation to Dual Momentum.

We don't know which signal will be the best in the future, so reliance on one signal could provide significant underperformance compared with investor expectations going forward. There's the added downside that a one-signal model has you all in or all out of the market.

For more information on these discussions and the added complexities surrounding them, look at:

A Better Look at Dual Momentum Fragility

Fragility Case Study: Dual Momentum GEM (Newfound)

Global Equity Momentum: A Craftsman's Perspective (ReSolve)

Valeriy Zakamulin's Research Papers on Trend Measurements

Whither Fragility: Dual Momentum GEM (Antonacci)

There are ways to reduce the risks associated with one-signal models, but they are not always easy to formulate or track for your average self-directed investor. It may not even be feasible or practical if your account size is limited.

However, part of the drawbacks on implementing more complex models correctly has changed thanks to Corey Hoffstein and the team at Newfound Research.

Newfound Research U.S. Trend Equity Index

Newfound Index Information with Link to Updated Excel File

The Newfound team have put together a long/flat U.S. stock trend index that is updated daily on their website. It is completely free and easy to follow. The depth of information put into this system, as well as the complexity of the numerous calculations involved, make this type of index very valuable.

Speaking as someone who is fairly proficient in Excel and has done a lot of backtesting, I can assure you it would take a lot of time executing data analysis, cleaning, and formulation on a spreadsheet to come up with even a semblance of this strategy on your own. The amount of data and calculation involved would probably have crashed your average computer fifteen years ago.

In this index, Newfound has taken three separate trend measurement styles and calculated them across 120 time periods for each style. This is a longer-term system that covers trends approximately six through twelve months in length.

  1. Time-series momentum: This is close to the trend measurement used in Dual Momentum. It simply looks back a specific number of days and determines the direction of the trend based on a positive or negative return during the period.
  2. Price minus exponential moving average: This is the simple moving average method where the trend is determined to be up if the price is above the specified moving average and down if it is below the moving average.
  3. Moving average cross-over: This method uses a shorter exponential moving average and a longer exponential moving average. If the shorter moving average is above the longer moving average the trend is up.

Put together, this complex index gives an investor an approximately equal exposure to 360 different individual trend models. In this index, Newfound has divided the 360 trend models into twenty separate tranches where each tranche is corrected to the signal weighting every twenty trading days.

To get a picture of the results, I've put together a few basic charts comparing the Newfound Research U.S. Trend Equity Index to the MSCI USA Index going back through 1970. On their site Newfound has data on the index from 1927.

Performance Chart

Credit: TheRichMoose.com, Newfound Research, MSCI Inc.

I would say the performance is very much what an investor would expect from a long-term trend style applied to a single market. We see avoidance of extended drawdowns, catches on the sharp and sudden corrections, and general outperformance over the longer term.

Drawdown Chart

Credit: TheRichMoose.com, Newfound Research, MSCI Inc.

In 1987, Newfound's index caught most of the drawdown experienced by U.S. stocks as a whole. As you might recall, the 1987 market crash was sudden and into a long-term uptrend. Every model that invests with long-term trends would have full, or nearly full exposure to the market in those conditions.

However, in every other major correction we see the Newfound index showing much smaller drawdowns. Even in 2008-2009, the worst U.S. stock bear market since the 1930s, Newfound's index lost a mere 11 percent as it methodically pulled stock exposure out of the investor portfolio.

3-Year Rolling Return Comparison

Credit: TheRichMoose.com, Newfound Research, MSCI Inc.

The lagging performance of Newfound's index in bull market phases can be seen when we look at rolling period returns. Newfound's index outperforms the U.S. market when stocks are falling and underperforms when stocks are in secular uptrends.

A drawdown has more impact on a portfolio than an upwards move (when measured in percentages). Combining the dynamic stock exposure with short-term bonds, the overall performance is positive and smoother than the S&P 500 Index.

Putting This Into Practice

If you are interested in following this model in your personal portfolio, you can click on the link I shared above and navigate to the Excel file that is available for download. The Excel file is regularly updated and contains all the information you need to follow the strategy.

Newfound has taken an easy approach with this information using two popular, low-cost ETFs: VTI (Vanguard's U.S. Total Market Index fund) and SHV (iShares' Short-term Treasury fund).

If the signal in the VTI column is "1", you fully allocate to VTI (or a similar U.S. stock ETF). If the signal in the SHV column is "1", you fully allocate to SHV (or a similar bond ETF). During transition periods there will be mixed signals across the 360 models. In this case, the column will specify the exact allocation to make to VTI and SHV.

If you don't want to make tiny trades because your portfolio is small or you are busy with other things in your life, I can't see the harm in checking the signal just once a week and making the portfolio adjustments as needed. Your returns will still be very similar to the index.

Summary

I'm excited to see good quantitative finance firms such as Newfound sharing this kind of detailed trend model with interested investors. This is quality research and quality information. My guess is only one in fifty knowledgeable investors could correctly calculate a trend index with this level of detail and complexity. At this stage in my life it is certainly well out of my league.

Not only does Newfound's U.S. Trend Equity Index show great historical results that are consistent with any long-term trend application to the U.S. stock market, the structure of the index is very diverse. This significantly reduces model specification risk.

In other words, it is highly likely that this system will provide investors with future returns that are close to what one would expect investing in any other longer-term trend model without the risk of chronic underperformance in any one trend measurement due to small changes in the market.

If the 12-month lookback period lags the 7-month lookback period over the next 20 years by 5 percent annually, no problem; each individual model only has a minute impact on the total portfolio. Same can be said for the small differences in returns between comparable time-series momentum and moving average measurements.

While this index is great in its own regard, it does not cover all the bases. It is not a replacement for Dual Momentum, shorter-term long/short strategies, or other trend strategies that provide exposure to different markets.

However, if you are invested in a passive portfolio with 60 percent U.S. stocks and 40 percent bonds, you should ask yourself why you are investing with that simple structure when a tiny bit more dynamism will drastically improve your results in absolute and risk-adjusted terms.

Also, if you are playing around with single market trend investing on the U.S. market at home, you should ask yourself if you can design a strategy that covers the range of risks even close to this one by Newfound.

Corey hinted the Newfound team will post more of these indices in the future. I'm crossing my fingers for a similar application with the MSCI EAFE and Emerging markets indices. Once those are available, it may be time to replace 12-month Dual Momentum or other more diversified strategies.

I will be playing around with Newfound's U.S. Trend Equity Index. I see some interesting applications when paired with a Leveraged Barbell Portfolio. It has also given me some ideas for further developing my own knowledge in more complex applications of trend investing.

Comments & Questions

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