Wednesday, October 31, 2018

What Today's Trend Following Sell Signal Implies For The Months Ahead

Summary:  With SPX closing below its 10-month moving average, a sell signal for a popular trend following system triggered today. This system has handily beaten the long-term performance of just holding SPX.

So what happens next? Using data from the last 38 years, there is an even chance that SPX reverses direction and moves higher from here over the months ahead. But the October low - or very close to it - appears likely to be retested in November.

* * *

After rising every month for 6 months since the end of March, and in the process gaining more than 10%, US equities fell hard in October. SPX dropped 7%, NDX 9% and small caps 11%.

This was the third worst month since the bull market started 116 months ago in March 2009; only May 2010 (flash crash) and August 2011 (European debt crisis) were worse.

The fall was enough to trigger a sell signal in a popular trend following system.

Trend following dispenses with the debate about recessions, the actions of the Fed, corporate earnings, valuations, China, investor sentiment, market breadth, and all the rest. It focuses purely on price and implicitly assumes that it reflects the most useful information available.

How does it work? As described by Meb Faber here, investors stay long when SPX is above its 10-month moving average (MMA) at month end and move to cash when it closes below. That's it. The system's long term track record is excellent (red line), handily beating the SPX (blue line) and 80-90% of professional investors (more on that here). Enlarge any chart by clicking on it.

Today is the last day in October, and SPX closed below the 10-mma for the first time since February 2016. From the buy signal in March 2016 to today, SPX's total return is almost 40%. 

What happens next?

There have been 21 sell signals since 1981 (in yellow). In 10 cases (48%), SPX started a rebound higher the next month (blue *).  So the current sell signal has an even chance of being quickly reversed.

Put another way, the trend following strategy primarily adds value by avoiding the large drawdowns that come from a bear market. In the charts above, note how the large falls in 1981, 1987, 1990, 2000-02 and 2007-08 were all side-stepped. These are precisely the types of events that far too many investors spend everyday obsessing over.

Mr. Faber shows this more neatly in the chart below; investors capture most of the upside and miss most of the downside that comes from holding the SPX through both ends of the cycle.

Where this strategy underperforms is in a grinding bull market. In 1982, 2003 and 2009, trend following investors bought back at significantly lower prices, but in between these periods, sell signals resulted in investors buying back higher than they sold. If the current slump is just volatility in an advancing bull market, trend followers will most likely buy back higher. That was most recently true in 2010, 2011 and 2016. This is the "cost" of avoiding drawdowns while trying to ride a trend. The reward is far better performance over periods of time that include both ends of the cycle.

A final conclusion - and watch out for the short term - is this: the recent low at 2603 on October 29 is likely to get retested.

In our SPX charts above, note the green highlights in 1985 and 1986. These are the only two dates when the "sell month's" low was not revisited within 1%. In 1985, the next month's low was 1% higher and in 1986 it was 1.4% higher.  In 91% of these 21 instances, the next month either closed lower or the intra-month low was within 1% of the "sell month's." Ignoring contrary evidence (described most recently here), that implies a very high likelihood of SPX trading back down to at least 2640 in the weeks ahead (1.4% above 2603), perhaps even lower. That is 2.7% below today's close.

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