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The Trend Is Your Friend

Posted on June 30, 2015

“Markets aren’t chaotic. Just as the seasons follow a series of predictable trends, so does price action.” – Jonathan Hoenig

2015-06-30_trend.jpgOne of the disciplines we have embraced here at Season Investments is called trend following. In its simplicity, trend following is an elegant solution to the age old conundrum of wanting (or needing) robust returns while simultaneously being unable to withstand the extreme volatility and drawdowns seen in the market from time to time. Unlike buy-and-hold, a trend following approach uses math to quantify the direction and the strength of the prevailing trend, and based on that analysis determines whether or not to be fully invested, partially invested or even all the way in cash. In doing so, this process offers the investor a built in stop loss against the types of major declines we saw in the bursting of the tech bubble and the financial crisis. 

In his book simply titled Trend Following, Michael Covel offers this summary.

Trend followers are the group of technical traders who use reactive technical analysis. Instead of trying to predict a market direction, their strategy is to react to the market’s movements whenever they occur. This enables them to focus on the market’s actual moves and not get emotionally involved with trying to predict direction or duration. 

In other words, trend followers respond to the market moves they can see rather than trying to predict the ones that are not yet visible

In extremely simple terms, the graphic below illustrates what this means. If the dotted line represents the price pattern for a particular asset, the green shaded areas represent the three dominant trends that existed over the shown time period. Notice that in this example the trend following strategy is not trying to trade every single wiggle and waggle in the price movement. This would indicate it is a model that is geared more towards intermediate and long-term trends rather than short-term patterns. Also notice that it does not endeavor to perfectly time the tops and bottoms, but rather it waits patiently for a new trend to be confirmed and then attempts to get in line with the bulk of that trend.

2015-06-30_Trend_Following.PNG

One thing trend following obviously presupposes is that assets do, in fact, move in trends. This is not always the case, and there are certainly time periods in which prices whipsaw back and forth in a sideways pattern. These types of environments are the bane of a trend followers’ existence, as back-and-forth price movements create “head fake” signals in which the investor is either buying or selling in anticipation of a new trend developing only to see the price reverse course and move against him. 

However, if given enough time a trend will always reemerge. The former head of research at John W. Henry & Company had this to say.

One of our basic philosophical tendencies is that change is constant, change is random, and trends will reappear if we go through a period of non-trending markets. It’s only a precursor to future trends and we feel if there is an extended period of non-trending markets, this really does set up a base for very dynamic trends in the future.

This is why trend following is a discipline, and that discipline, like any other, will require some patience from time to time. Sometimes this patience may be needed for extended periods lasting multiple years. Consider an environment where the markets are locked into a smooth, steady uptrend. Making money in this environment is not difficult, and after a while it might not seem obvious why anyone would even need a trend following strategy in place. On top of that, perhaps the model has produced a number of head fake signals that reduced returns slightly below what would have otherwise been earned with a buy-and-hold strategy. It’s during these times that it’s important to remember the whole point of using trend following in the first place. The point is not to squeeze out every ounce of upside in the bull markets, or even to get a high percentage of the individual trading signals right. Rather, the point is to have a stop loss mechanism in place to protect your capital against a deep and sustained drawdown in value. 

Thus, the value-add of a trend following strategy might come from only a handful of great signals every decade. Thinking about the last ten years, for instance, having a stop loss in place during the financial crisis could have been enormously impactful to someone’s long-term results. Richard Lehman, in his book Far From Random, speaks along these same lines. 

A prevalent view of trend analysis holds that it is the province of traders and is not geared to the longer term horizon of “investors”. On this I could not disagree more. While it is essential for short-term traders, it can be equally valuable for investors with any time horizon. Its use would be justified with even just one technical signal in years of investing that indicated a major market turn. Without any technical aid in decision making, one is doomed to be a long-term buy-and-hold investor with no way to exit the market except as a result of no longer being able to stand the pain of loss.

At the end of the day there is more than one singular way to reach your long-term investment goals. For the reasons discussed above we believe that a disciplined trend following approach is an attractive and elegant option since it effectively addresses the two inherent limitations of buy-and-hold: the human element and uncertain timelines. It also takes the guesswork out of buy and sell decisions by basing those decisions on mathematical models instead of on gut convictions. In short, a good trend following strategy can offer the potential for similar returns over time with less volatility and drawdown exposure. In next week’s Insight we will continue this conversation be providing a summary overview and a performance update on our two flagship trend following strategies, MarketVANE STOCKS and MarketVANE HARD ASSETS. In the meantime let’s all reject the Great Lies being touted by the financial industry and seek out more sound truths upon which to build our long-term investment strategies.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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