Trend following the UK stock market - a timing signal update

With stock markets wobbly, it's a good moment to review the trend following model I've published occasionally over the last year. There is a well-known premise that asset prices have had a tendency to trend, and stock markets are no exception.

Brief primer on trend following

One of the simplest approaches to trend following is to compare the price of an asset (like the S&P 500) against its average price over a certain look back period. You buy the asset when the price moves above the average, and sell when it moves below. As prices change over time, the average is known as the moving average and can be plotted against the price in most chart packages, including ours.

Below shows the S&P 500 versus the 200-day moving average (200d MA).

There's been a great deal of research performed on the profitability of such an approach, with a particularly readable study by Meb Faber in "A Quantitative Approach to Tactical Asset Management".

He showed that in US markets between 1901 and 2012, buying the S&P 500 when it's above the 200d MA, and staying in cash when below both increases annualised returns (from 9.3% to 10.2%, and reduces downside volatility considerably (from  17.9% to 12.0%. Aside from these benefits, trend following reduces the maximum drawdown considerably (from 83% to 50%.

One great insight from Faber in a follow-up paper is that stock markets get far more volatile when they are below the 200-day moving average than when above. Not only this, but returns are lower too.

  "On average, returns are 60% lower and the volatility 30% higher when the market is below 10-month simple moving average."

He reasons that humans use different parts of their brain when markets are downtrending than uptrending, which drives volatility in bear markets. Apparently, we use the same part of the brain that's stimulated by cocaine or morphine when markets are rising, but we use the flight response part of the brain when downtrending.  

Applying trend following to individual shares

Of course, the above study was performed in the US and on a benchmark index - the S&P 500. Dealing in an index product like an S&P 500 ETF is pretty cheap, but if you are an investor directly investing in individual shares, then implementing a trend following system is trickier. The transaction costs of buying and selling individual shares based on the market index trend can eat you up. So what's the solution?

A good model is outlined in Andreas Clenow's excellent "Stocks on the Move". Clenow is a well-known investor, writer and pythonista. His book is a great read and recommended for any serious momentum investor's bookshelf.

He outlines an easily implemented approach that only deals on Wednesdays.

• He buys a portfolio of his highest-ranked momentum shares only when the overall market index is above its moving average.
• He uses some simple sell rules on the individual shares (if the share's rank falls below a cut-off, if the share falls below its own moving average, or if it has a 15% gap, he sells).
• If the overall market index drops below the moving average, he stops buying new positions. Cash is gradually raised when individual position sell rules are triggered.
• Cash is reinvested fully in new high ranked positions only when the index is above its moving average again. 

Even without the market trend filter, the approach beats the S&P 500 handsomely 9.1% annualised return versus 5.2% return from 1999 to 2015 at lower risk), but with the market trend filter the strategy returns 12.4% annualised, with a maximum drawdown of only 24% versus 55% for the index.

A trend following rule of thumb

One of the great insights from Clenow's approach is that it provides a great rule of thumb for successfully navigating difficult stock markets.

  Only buy new positions when the market is in an uptrend.

I know many on this site are bargain hunters, and downtrending markets serve up many bargains - so the above rule of thumb may not be popular. However, the maxim "don't try to catch a falling knife" is wise and worth remembering. Indeed, Meb Faber has shown that all stock market returns can be captured during uptrends, with lower volatility.

Discipline is everything.

Insights on the trend state of the UK stock market

One of the curious traits of the FTSE 100 is that it hasn't given good trend signals for decades. Trend following the FTSE 100 has been a fools errand - or at least has been for more than 30 years. The UK bellwether index is really a dividend machine, and trend followers should give it a wide berth - see my backtest below in orange.

But as mentioned on January 13th, the FTSE AIM All Share - which is the aggregate of the LSE's junior market stocks - is highly sentiment-driven and trends rather beautifully at times. As explained in the article, I prefer to use the 120-day moving average on this index. While the overall index has lost money over more than 25 years of history, the trend following model returned 50x over that time period, which drops to 12x when adding a 2% transaction cost drag.

Of course, in downtrending markets, the trend signals can get a bit choppy at times. After a bullish signal on January 12th, we've seen a bearish signal on March 13th.

Previous periods like this have seen choppiness in both directions, and of course, with all the banking shenanigans, there's downside volatility risk. The US Federal Reserve tends to increase and decrease rates until it breaks things, and rarely pivots dramatically until something goes horribly wrong. Yes, SVB, Signature Bank, First Republic and Credit Suisse are signs of things breaking, but deposits have been generally guaranteed. How long this approach holds out I don't know.

So, what am I doing? Well, I initiated a new family portfolio on January 16th, just after the uptrend signal, investing 1/3 of the capital in a set of 6 value/momentum names. They did rather well, increasing 12% by March 6th - mostly due to Yu (LON:YU.) and Kitwave (LON:KITW) . But those gains have now been given up, with the portfolio now flat. My pre-intention has been to invest another third after 3 months, but only if the market trend filter is in an uptrend. As per Clenow, Faber and my rule of thumb, I won't be initiating any new positions until it does so.