As the Vulcans say, ‘Live long and prosper’: trend-following offers one way to do so

    As the Vulcans say, ‘Live long and prosper’: trend-following offers one way to do so

    Techniques to beat the market

    1 October 2016

    To say that we are in some kind of ‘new normal’ investment environment barely does justice to the surreal state of the financial world — a world of negative official interest rates in which, for example, Danish property owners are paid to-borrow money while their Swedish and German cousins respond by saving even more. Quantitative easing has so distorted asset prices that $13 trillion of government debt globally now trades with a negative yield: anyone dumb enough to be buying this junk is mathematically guaranteed to lose money. It’s certainly time to be checking what your pension-fund manager or financial adviser has been buying on your behalf.

    How we ended up in this mess is relatively straightforward to understand. We’ve lived through a 40-year credit binge and the collapse of US property markets in 2007 suggested that our global credit expansion had finally run into a brick wall. Rather than accept hard reality, the world’s central banks decided that the banks would be saved and the credit expansion would continue, whether anybody wanted it to or not. So interest rates were slashed, and when they reached the so-called ‘zero lower bound’, they were slashed some more.

    Strange things happen at and below the ‘zero lower bound’. The prices of many financial assets (equities, bonds, property, sundry rich boys’ toys) take off into the wide blue yonder. But what is the prudent investor to do? Sheltering in cash hardly seems the answer: negative interest rates may well be coming to the UK, too, if recent correspondence from my bank and Sipp provider is anything to go by.

    But most bonds have become uninvestible, and many stock markets,-courtesy of QE, seem priced for perfection and then some. There are risks to one’s capital as far as the eye can see. Such a desperate situation warrants an unorthodox investment response.

    There is a style of trading that has been successful for centuries but which remains off the radar of most investors, whether individuals or institutions. That it remains widely overlooked by the mainstream adds to its appeal today. Perhaps 99 per cent of fund managers attempt to predict the future — and most do a pretty poor job. But there is an intriguing 1 per cent who make no attempt to predict but merely respond to the price signals of the past. They are known as-systematic trend-followers. ‘Systematic’ because they follow a system. ‘Trend-followers’ because they seek to catch rides on strong price trends. Whether prices for a given instrument are trending higher or lower, they don’t care: what they want is a trend, plain and simple. Their worst-case scenario is a market going sideways.

    A typical trend-following fund, at any one time, will be monitoring prices across multiple markets: equities; interest rates; currencies; commodities; anything that trades on a futures market. They favour futures markets because these markets are the-deepest and most liquid in the world. You can buy shares of BP, BT and Glaxo, but if you’ve got hundreds of millions of dollars to put to work, you’ll be better off buying FTSE index futures, and you won’t move the price so much in the process. When their system tells them that a given instrument is in the midst of a strong uptrend, as gold currently is, then they simply buy a small-holding, perhaps with a ‘stop loss’ to-protect future gains. If gold continues to rise, they’ll buy some more, perhaps adjusting the stop loss.

    But trend-followers are just as happy to sell as to buy. The beauty of trend-following is that it’s utterly unemotional: all that matters is the price. If it’s rising, then buy; if it’s falling, sell. If Star Trek’s Mr Spock ever had a favourite trading strategy, it would have been trend-following.

    And he would have found that it works. A friend of mine recently crunched some data on the world’s top performing funds. To make it on to his ‘all-time best’ list, a fund needed to have at least a 20-year audited track record and to have returned, on average, 20 per cent a year. Just 11 made the final cut. Of those, six were systematic trend-following funds.

    But it’s not just about returns: it’s also about risk. 2008 turned out to be one of the worst years for financial markets in living memory. How did trend-following funds do? They all made money. Winton Futures, one of the more conservative trend-followers, made 21 per cent after fees. Mulvaney, one of the more aggressive trend-followers, made 108 per cent. In one of the worst years in living memory, that is. The-reasons are straightforward: most fund managers have little option but to own the market, or perhaps shelter some of their portfolios in cash. But for trend-followers, when the market starts to fall, they unemotionally sell short as it goes down, then wait for the bounce.

    There’s another reason to consider trend-following funds as part of a balanced portfolio. Their-correlation to stock and bond markets has historically been close to zero. So if you own a portfolio of stocks and bonds, it makes perfect sense also to own an asset class that has no particular link to the price performance of those other classes. This is simple portfolio diversification. Other fund managers in this market include Man AHL and Dunn Capital — but do you own research into the sector ( is a good place to start) and be sure to check on minimum investment thresholds.

    For trend-following to remain relevant in financial markets, just one thing needs to happen: human nature needs to remain as is. For as long as investors are prone to cycles of greed and fear, markets and prices will form trends. Trend-followers don’t attempt to predict those trends, merely to ride them for as long as they last. So the best trend-following-managers have no view about the market at all: they try to-maintain an open mind and are simply concerned about-mechanistically conserving the capital they manage in order to live to fight another day.

    Grotesquely expensive stock and bond markets. Zero or negative interest rates. Heightened concerns about bank risk, especially in the eurozone (again). Rather than sheltering meekly in cash or braving the squalls, how about putting some money to work in one of the most successful long-term trading-strategies ever devised?

    Jonathan Davis says moving averages can reliably tell you the time to get in or out of the market

    What do you want the stock market to do for you? Make short-term speculative gains, or grow your wealth over a period of years? My answer would be: ideally both — but the wealth part is by far the more important of the two. The-question is: what can a wealth-seeking investor do to minimise the risk of losses along the way? Here’s one technique that might help.

    The starting point is to recognise that the stock market — to borrow a phrase recently used by one MP about the Governor of the Bank of England — is an ‘unreliable boyfriend’. It is emotionally unstable and prone to violent fits. The prices quoted in the market every day are far more volatile than the fundamental facts about economic life they are supposed to reflect. In the last 20 years there have been two spectacular bear markets. On each occasion the stock market has fallen 50 per cent and then rebounded by between 70 and 100 per cent. Yes, profits and the wider economy took a hit in both cases, but the hit was temporary and nothing like as sharp as the market movement.

    And it is ever thus. Professor Robert Shiller, the Nobel laureate economist, has researched the-history of market returns and found that if investors 100 years ago had enjoyed perfect foresight into what company profits and dividends were going to be over the next century, the market would never have yo-yo’d around as dramatically as it has. Fundamentals just don’t change as often or as fast as share prices.

    But given the instability of investors’ decision-making, those savage market corrections are bound to come round at regular intervals. Would it not be comforting if there was a way to make sure you missed the worst down-draughts while still capturing most of the gains in the up years?

    There is no absolutely foolproof way to ensure that, but a few tricks can help. The key is to tune out the daily noise that spews from the media every day and concentrate on longer-term trends that determine how much your wealth appreciates over time. Those trends can be difficult to follow unless you know where and how to look for them, but one very simple way is to use moving averages of main market indices such as the FTSE 100 or FTSE All-Share.-Professionals commonly use a 200-day-moving-average —the-average price at which the index closed over the previous 200 trading days, thus capturing about 8.5 months of a typical year’s market action.

    Plotting the moving average on a chart — easy to do on almost any stock market website — will give you a snapshot both of the broad direction in which the market is moving and where today’s index level stands in relation to recent history. For example, the chart on this page shows the ten-year picture for the FTSE All-Share index. The jagged line is the weekly price movement, while the smoother single line is the 200-day moving average.

    When to be in, when to be out: the 200-day moving-average offers a simple guide that requires very little effort to follow

    Now for the interesting part. In an ideal world, ignoring daily movements, your aim would be to be in the market when the 200-day average is rising and out whenever it is clearly falling. It is particularly important to be out of the market when the index has fallen decisively below a falling 200-day moving average, as invariably happens in the worst bear markets.

    Looking at the chart, and using only month-end prices, that simple rule would have taken you out of the market in late 2007 and kept you out until mid-2009. You would have taken a break in mid-2011 until early 2012 (the eurozone crisis) and again from mid 2015 until Q2 this year. Post-Brexit, you would still be in the market — and so far handsomely rewarded for it. Even though you miss the first part of each new bull phase, you’re still comfortably better off than if you had stayed fully invested all the way through.

    An American analyst, Meb Faber, has analysed what would have happened if you had consistently adopted a similar technique in the US stock market since 1901. He uses a ten-month rather than 200-day moving average, but that does not affect the result by much. The results are striking. An investor who followed this course would have generated higher returns and lower volatility, with much smaller-periodic losses, than anyone who remained fully invested throughout the markets’ ups and downs.

    The great beauty of this kind of approach is that it requires very little effort. You need only to look at the market’s level once a month and make a simple binary decision at that point: stay in or pull out. The moving average tells you what to do. You don’t have to listen to pundits or open a newspaper.

    It’s fair to say that investment professionals hate this kind of approach, which you can also apply to other asset classes such as bonds, property and gold. Market timing, they will tell you, is a sin — which it is if you are trying to move in and out on the basis of your or their judgments of whether the market is under or over-valued. Nobody I know has ever been able to make that work consistently.

    It is also true that this kind of rule-based investing, attractively simple as it is, is most useful when your investments are held in a tax wrapper such as an Isa or a Sipp. Buying and selling your entire holding once a month, easy though that is easier to do these days if you use ETFs or index funds, becomes potentially expensive if you have to pay capital gains tax along the way. For many moving-average investors that is not a problem, though, given the generous annual-tax-free allowances on offer.

    So there are some difficulties, but in my experience tracking the moving averages of the market indices, even if you only use them to monitor your portfolio, has proved an invaluable help over the years in-judging where we are in the market cycle. Try it out on paper first if you don’t believe me. Its great merit is cost-effective simplicity— and that’s good for your peace of mind as well as your wallet.