Trend-following works only if the trend holds.
Trends are core to technical analysis, the dark art of studying stock charts to divine whether prices will rise or fall.
Admittedly, I have poked fun at technical analysis, including in the title of my presentation for Interactive Brokers clients at noon ET today, where I ask rhetorically how many rich technical traders do you know?
Technical analysis is the study of patterns to understand prices. There are moving averages over different periods, and patterns like golden triangles. The crop circles of the stock market.
I’m kidding about crop circles.
There’s a measure of merit to these strategies. They’re quantitative techniques in a stock market gripped by averages. That performance tends to be average is a product of the explosive growth of Passive Investment wanting to be average – the benchmark. And of market rules that force all trading toward midpoint prices (which is the average).
Speaking of which, the Nasdaq just launched the first order type powered by Artificial Intelligence. Called cleverly M-ELO, the Dynamic Midpoint Extended Life Order is a trading construct meant to match two parties willing to extend the period over which they engage in buying and selling.
The algorithm will aim to gather a larger portion of the trade near midpoint prices (unsurprisingly). That’s in part because prices are wildly unstable. The average stock in the S&P 500 moves about 2% between intraday highest and lowest prices.
Coincidentally, 2% is the outer edge of limits on tracking errors that index funds try to achieve. That is, they don’t want investment performance to vary more than 2% from the index the fund tracks, or regulators may investigate them for failing to deliver the investment objective.
Who cares? Well, both investors and public companies should know. Trend-following works only if the trend holds.
One of the largest trend-following funds, AlphaSimplex (owned by Virtus, a publicly traded asset manager overseeing $169 billion), say it’s “developed systematic, quantitative alternative investment strategies that are attuned to changing market dynamics.” The firm aims to help investors “meet their long-term goals in ever-evolving markets by analyzing market behavior and risk.”
We at ModernIR agree with analyzing market behavior and risk, and that the market is ever-evolving and certainly not as it was when technical signals were developed.
Anyway, like most big trend-following funds, AlphaSimplex uses managed futures strategies. That is, they buy and sell baskets of closely monitored futures contracts to achieve returns.
And to some degree, they work. Société General runs the SG Index, a benchmark predicated on the returns of the ten largest trend-following investment managers. The Trend Index is down less than a percent YTD in 2023 versus a 17% gain for SPY, the State Street ETF tracking S&P 500 stocks. But since 1999, trend-following strategies are up more than 250%.
That’s still less than the benchmark. More telling, a review of the trailing data shows heavy concentration of returns prior to 2009. It’s been pedestrian since. I attribute it to how Regulation National Market System, the rulebook governing stock trading, painted the market with uniformity and entrenched average prices.
It’s hard now to find outlier trades. There’s a sameness to the money, which is heavily concentrated in the largest thousand stocks.
And over 85% of trades are derivations of midpoint. Why? They follow the trend and track the benchmark. The rub is, you get the market’s performance. Beta. Not alpha.
And technical signals are backward-looking. These measures assume prices creating – pick your period, 50-day, 200-day – moving averages are equal. What if 75% of the prices are set by behaviors with a horizon of a day or less? How reliable are those prices five days from now?
I conclude that technical signals tracking average prices invariably thus conform to the benchmark. Public companies, the probability ANY of your stock-picking holders outperform the benchmark is small. Statistically, less than 1%.
(That’s not a bad thing! It means you should shift from trying to deliver alpha, to aiming at beta. It’s a story I’ve told before).
And traders? If you’re trend-following, you’re probably overpaying for market performance. You could just buy beta by trading the S&P 500. The secret to beating the benchmark is WHEN you buy it, and when you sell it or short it. And that secret doesn’t reside in long-range moving averages but short-range changes to supply and demand.
Tally the up days and down days in SPY from Jan 3, 2022 through Sep 11, 2023, and the market is down 210%, up 208%, for a net gain of 2%. Volatility destroys returns. Eliminate just 10% of down volatility and you crush the benchmark.
I’ll cover some of this today in my IBKR webinar. Feel free to tune in and heckle!
And public companies, volatility is the enemy of passive money. Guess what happens when you report earnings? Hedge funds and trading machines make directional bets that foster volatility – the very thing that harms shareholder-value.
What to do? That’s another story. The good news is there’s an answer.