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Playing Defense

Posted on January 15, 2019

“If you are not aggressive, you are not going to make money, and if you are not defensive, you are not going to keep money.” – Ray Dalio

2019-01-15_defensive_chess.jpgIn this week’s insight we’re going to take a fresh look at how our trend following strategy has us positioned as we break the seal on 2019. The last two years have been incredibly interesting for stock market investors of all types. As we’ve profiled a number of different times in our Weekly Insights, 2017 was an unusually calm year in the market. Ben Carlson recently pointed out on his blog that it was the only year on record in which the S&P 500 did not register a single negative month, and there were only four trading days which saw losses in excess of 1%. But perhaps most amazing to us…there wasn’t a single trading day in 2017 in which the S&P 500 was up or down by 2% or more! 

These statistics are mind blowing, especially in comparison to how the market behaved in 2018. As we all now know, volatility and downside risk have returned in a big way since the “Slowmentum” of the year prior. In particular, the final months of 2018 saw a drawdown of ~20% (the commonly accepted definition of a “correction”) that was the fastest drop since 1998 when the market fell by a similar amount in just 45 days. 

On November 27th in Is Cash Really Trash? we described how MarketVANE STOCKS had moved to 20% cash at the end of October and then 40% by mid-November. This was followed by another signal at the end of the year which took us to an 80% cash position within that model.


MarketVANE is not the only trend following model that is moving to a hedged position. As we described around this time last year in Same Roots, Different Fruits, we’ve employed several other managers with differing “flavors” of trend following alongside MarketVANE. Of those three managers, one of them is still currently fully invested while the other two are 70-100% hedged. As a result, we are entering 2019 with an extreme underweight versus long-term targets in our stock market allocations.

The very nature of trend following is such that while we will spend much of our time fully invested there will be periods where we carry large amounts of cash. During these period we would fully expect to produce significant tracking error to broad market benchmarks. As we’ve explained in the past, the majority of these cash signals will end up being nothing more than “head fakes” in which the market resumes its uptrend and we lose out on a bit of upside before getting back to a fully invested position. In theory, those head fakes are more than paid for during the large bear markets that tend to occur on average once or twice a decade. While these events are fewer and farther between, they are large enough to make up for whatever amount of opportunity cost has been incurred along the way with the head fake signals.

It’s always a bit nerve racking being in this position. It’s a simple fact that when we hold a lot of cash the tracking error vs the market is going to do one of two things - help us or hurt us. If the downturn continues, and especially if it turns into a deep and prolonged bear market, we should post very attractive results relative to a buy-and-hold strategy. However, if the market bounces sharply from here the cash signals will cost us some upside and in hindsight we will have been better off just holding through the dip and recovery. Again, we have to assume this is going to be the case the majority of the time, while trusting that the protection this approach provides in the next major bear market will be more than enough to make up for it.

To better illustrate this dynamic let’s look back at two historical signals using the back tested data of the latest iteration of our proprietary trend following model, MarketVANE STOCKS. Please note that these illustrations are representative of hypothetical signals of a back tested model – they are intended to illustrate the way a trend following discipline may work (or not work) in different market environments and are not intended to depict actual results.

First, to illustrate a cash signal that is representative of a “head fake”, we rewind to the late summer of 2015. After a couple of rough months in which the market became choppy and started trending lower, the model shows a movement to 80% cash in mid-September…just in time to miss a sharp “V-shaped” bounce in October. Over the next several months the model moved in and out of cash before the market really settled into a new uptrend in March 2016. While cash positions certainly would have cut down on some of the volatility along the way, in the final analysis MarketVANE STOCKS was unable to make up for the lost opportunity in October and incurred a “cost” of 5.75% for the full period.


In contrast, let’s rewind a few more years to the financial crisis to look at a hypothetical signal that would have worked out really well. As shown in the chart below, MarketVANE STOCKS would have begun moving into cash in mid-July, and would be completely out of the market by mid-October of 2008. The duration and magnitude of the declines during the period would have made it easy for the cash position to result in a tremendous amount of positive tracking error vs the market, and despite missing out on the first leg of the recovery in March and April the model still comes out ahead by over 22% for the duration of the trade.


We obviously don’t know what 2019 will hold for the stock market. The pullback may already have run its course, in which case we will miss some of the upside between now and when the various trend following strategies we allocate to move back into fully invested territory. Alternatively, perhaps we’re still in the early innings of the downturn and a bear market is set to unfold in the New Year. In that case our defensive positioning will pay off nicely for clients, and we will effectively preserve capital throughout the downturn. We can’t help but feel a bit anxious given our extremely conservative positioning, but it’s important to remember that the market will make you squirm from time to time regardless of the investment approach you adhere to. We continue to believe that despite the risk of head fakes, there are times when playing good defense for our clients makes more sense than remaining fully invested all the time.

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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