Back In The Tool Bag
“This is quite a shift from 2008, when most trend-following hedge funds profited from massive, sustained falls in stocks and oil, and a bond rally.” – Robin Wigglesworth, Financial Times
At Season Investments our investment philosophy has always emphasized proactive risk management. We believe making money over long periods of time is as much about avoiding large periodic losses as it is about squeezing out all the upside, so philosophically we have always been willing to accept the trade-off of lagging in strong bull markets if it meant being able to outperform by preserving capital in a downturn.
Achieving this is easier said than done. Risk management is not a singular event or one time “yes or no” decision. Rather, it is a process that involves imperfect and incomplete information, has no standardized set of rules, and will never reach a natural end or conclusion.
Our approach to managing risk has historically utilized trend following as one of its primary tools via proprietary models and outside managers within several asset classes, most consequentially in stocks. Over five years ago in our post The Trend Is Your Friend we described trend following as follows:
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.
The intention of trend following has always been to try to capture the bulk of the big up moves while cutting off losses incurred in the deep and sustained drawdowns. There is only one problem: after decades of strong risk-adjusted performance, intermediate-term trend following strategies have failed miserably in recent years.
This disappointing stretch was recently profiled in a Financial Times article, in which they point out that following several years of lackluster performance this year has been especially tough. Edward Raymond of Julius Baer describes 2020 as a “crucible” for trend following strategies, and the article’s author laments the recent fall from favor in the opening quote above.
Indeed, leading up and through the Great Financial Crisis trend following strategies had built a long and compelling track record of performing well through thick and thin, and particularly in turbulent market environments. Following their stellar performance in 2008 such strategies became increasingly popular amongst institutional investors, including us, who have since been disappointed by the discipline’s performance. The nearby chart (taken from the same Financial Times article) shows how assets invested with trend following managers exploded roughly a decade ago before starting to flow back out of these same strategies over the past two years.
So what’s going on here, and why has trend following struggled so much in recent years? Pensions & Investments magazine recently published an article addressing this question in which they state,
Wall Street strategists have pointed out that despite lower volatility, credit and stocks have seen more abnormal moves — or fatter tails, in statistical parlance — in recent years. That's a bane for trend followers because many of them use a medium-term time horizon of about a few weeks to months to determine momentum.
Sara Wolkoff, head of investor relations at a $6 billion asset manager, put it more simply in pointing out that, “any corrections to the sustained, largely one-way trend in equity markets have been brief, sharp and without follow-through.”
Indeed, stock market selloffs have played themselves out - and subsequently reversed course - far more rapidly than “normal” as compared to historical market behavior. The term “V-shaped” has become ubiquitous in financial lingo in recent years because of these patterns. This has created a tough environment for intermediate-term trend following models that have not been able to keep pace and have effectively been “head faked” by the sharp, violent moves in the market.
We touched on these very dynamics, and how they were being perfectly seen in the COVID-related selloff, in a series of client emails back in March. To update the illustration, we went back and looked at all the drawdowns of at least 34% (the peak-to-trough COVID-19 drawdown) since 1950 in the S&P 500. The contrast between this latest drop and the other five in the analysis is stark, with the closest comparison being Black Monday in 1987 when the market fell over 20% in a single day. This chart clearly illustrates just how quickly the COVID-19 selloff occurred.
While the early 2020 selloff was really the first “big one” that we have seen since the Financial Crisis, the nature of multiple other market corrections since that time has been the same – short, violent and followed by quick reversals. In other words, while the market dynamic illustrated in the chart above is dramatic, it in no way stands alone as a one-off event. Rather, it’s characteristic of the way the market has been behaving for many years now.
But all of this only describes what has been happening that has made for a difficult environment for trend following. We have yet to theorize as to why it is happening, or just as importantly, whether it is a temporary aberration or more of a structural shift in the market that is here to stay. These are the questions we have been laboring over for some time now. Every V-shaped market event has caused us to further question whether intermediate-term trend following can still be expected to add value over the long term, or if something is permanently different.
While these are questions that can never be answered with perfect certainty (no one knows the future), the market action thus far this year has solidified our conviction that the following three dynamics are working to exacerbate the current market dynamics:
1) LEVERAGE. Corporate indebtedness is at historically high levels. In addition, financial markets are chock full of margin and derivate contracts which are in essence adding leverage to the bets being made on already leveraged assets (see Perpetual Money Machine). This is adding fuel to the fire of any market correction resulting in sharper, more violent corrections. Case in point: much of the selling during COVID-19 collapse was being driven by margin calls and forced de-levering amongst market participants – not by fundamentals.
2) COMPUTERS. Buying and selling stock was much harder thirty years ago. Today, putting a trade in is only a couple clicks away on a desktop or mobile device. What’s more, much of the trading volume during selloffs is now being driven by algorithms that are pre-programmed to sell once certain downside limits are hit. Again, this exacerbates downward moves in the market as knee-jerk investor reactions and computer-driven trading serve to pile on and drive the market lower indiscriminately.
3) POLICY MAKERS. The Financial Crisis triggered what, at the time, was considered unprecedented fiscal and monetary policy support for the economy and financial markets. The phrases “shock and awe” and “pulling out the bazooka” were used to describe the interventions deployed by Bernanke’s Fed and the US Congress. Suffice it to say that yesterday’s “unprecedented” is today’s “new normal.” Policy responses to the pandemic, which dwarfed anything done in the Financial Crisis, have further solidified the growing consensus that stocks only ever go up, and every dip is a buying opportunity.
Given recent performance, and for the reasons above, our confidence in intermediate-term trend following as an effective risk management discipline for stocks has been severely shaken. Future evidence and changes to the market environment could persuade us otherwise, but we don’t see these realities reversing course anytime soon. As a result, we have decided to move away from trend following in our stock market allocations. While this doesn’t change our dedication to and belief in proactive risk management, we are deciding to put this particular “tool” back in the bag, at least for the time being.
This has been a difficult decision to make given our historical endorsement of trend following as a core discipline. That said, a recent post from Ben Carlson reminded us of an important truth:
Far too often people judge decisions exclusively on the outcome, not the process that went into the decision in the first place. Even when you put the odds in your favor, you’re not always going to like the outcome…In short, think process over outcomes.
We recognize that, although we haven’t liked the outcome, our decision to utilize trend following strategies in recent years was based on careful research, rational analysis, and a robust decision-making process. That said, the process itself must be ongoing as we monitor and seek to understand results. Regardless of how we feel about any decision, we should always be willing to pivot when its warranted. As Keynes purportedly said, “When the facts change, I change my mind.” The process that led to this conclusion involved countless hours of research and discourse, both internally and with clients. It was uncomfortable, but it was deliberate and thorough. Most importantly, it wasn’t the first time, nor will it be the last, that we’ll have to take a critical look at our investment strategy and make a tough decision to pivot. Risk management is a process, and that process won’t ever stop as long as we’re tasked with the stewardship of our clients’ resources.
Author 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.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.