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A Few Notes on Trend Following

Posted in Big Ideas, Strategic Allocation

Michael Covel prefaces the 2017 Fifth Edition of his book, Trend Following: How to Make a Fortune in Bull, Bear, and Black Swan Markets, by stating that: “The 233,092 words in this book are the result of my near 20-year hazardous journey for the truth about this trading called trend following. …Trend following…aims to capture the majority of a connected market trend up or down for outsize profit. It is designed for potential gain in all major asset classes–stocks, bonds, metals, currencies, and hundreds of other commodities. …if you want outside-the-the-box different, the truth of how out-sized returns are made without any fundamental predictions or forecasts, this is it. And if you want the honest data-driven proof, I expect my digging will give everyone the necessary confidence to break their comfort addiction to the box they already know and go take a swing at making a fortune…” Based on his experience as a trader/portfolio manager and the body of trend following research, he concludes that:

From Chapter 1, “Trend Following” (Page 15): “Instead of trying to predict market direction (an impossible chore), trend following reacts to movements whenever they occur. This enables a focus on actual price risk, while avoiding becoming emotionally connected with direction, duration, and fundamental expectations. …Trend following works because you don’t try to outthink it. You are a trend follower, not a trend predictor.”

From Chapter 6, “Human Behavior” (Page 190): “But why should trends continue? If prices initially underreact to to either good or bad news, trends tend to continue as prices slowly move to fully reflect changes in fundamental value. These trends have the potential to continue even further as investors herd (or chase trends). Herding can cause prices to overreact and move beyond fundamental value after the initial underreaction.”

From Chapter 7, “Decision Making” (Page 210): “Trend following is inherently simple. …The reason trend followers do well is because they stay focused and very disciplined.”

From Chapter 10, “Trading Systems” (Page 263): “When you mechanize a trend following trading system, you take all discretionary judgments and build them into rules. …The logic is to hardwire all scenarios you could possible see in advance across your portfolio.”

From Chapter 19, “A Multicentennial View of Trend Following” (Page 401): “Over the centuries, empirically, trend following has provided distinctly positive returns, a high Sharpe ratio, as well as low correlation with traditional asset classes, inflation, and interest rate regimes. The strategy provides consistently positive performance during crisis periods…”

From Chapter 20, “Two Centuries of Trend Following” (Page 423): “[This study establishes] the existence of anomalous excess returns based on trend following strategies across all asset classes and over very long time scales. …the suggestion that long-term trend following has become overcrowded is not borne out by our analysis…” [See “Trend Following over the Very Long Run”.]

From Chapter 21, “Trend Following: Quality, Not Quantity” (Page 434): “The best approach is to focus on building a single, well-researched trend following model that integrates key features of many different trend following approaches…”

From Chapter 23, “Black Box Trend Following–Lifting the Veil” (Pages 468-469): “…CTA indexes can easily be duplicated using simple, well-known trend following filters such as moving averages and channel breakouts. Models based on these trend filters have performed well as standalone investments. These models have approximately -50% correlation to the SP500 when it is down more than -3% in a month. The hedging characteristic of these models comes without a commensurate downside during strong stock market periods.”

From Chapter 25, “How to GRAB a Bargain Trading Futures…Maybe”(Pages 489, 494): “…a computerized trading system that buys retracements [buys low] and sells rallies [sells high]…is a loser.” [This strategy is the converse of trend following.]

From Chapter 27, “Carry and Trend in Lots of Places” (Pages 546-547): “…the combination of positive-carry and positive-trend positions is without exception better than negative-carry and negative-trend positions over each historical period and for (almost) every asset class and across rate regimes. …positive-trend strategies can match and even exceed positive-carry strategies over a wide combination of periods and assets… …if positive-carry positions cannot be found, positive-trend positions that minimize negative carry are high-expected-return strategies.” [See “Carry and Trend Implications for Future Returns Across Asset Classes”.]

In summary, investors will likely find Trend Following a plausible and research-supported argument for tactical trend following in many markets.

The book relies heavily throughout on quotation of practitioners and academics.

Cautions regarding conclusions include:

  • Some investors may find large overlaps in market discussions and research summaries with other books and sources. 
  • The book is essentially a distillation of expert beliefs and a partial survey/summary of general investing research and trend following research. It does not present and test any specific trend following strategy for readers to adopt.
  • Seeking successful practices by studying/interviewing high-performing investors and other experts potentially involves sample selection bias and the barrier of trade secrets. For example, it is possible that failed investors employed processes similar in some ways to successful investors. It also seems reasonable that high-performing investors do not reveal key methods.

See also many research summaries in “Momentum Investing” and “Technical Trading”.

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