Ok, you caught me watching a bit too many “Big Bang Theory” reruns. I am a geek at heart. My wife would argue there is no heart about it!
The fact of the matter is that Superman had his weakness, the fictional Kryptonite that brought him to his knees and trend followers have theirs. The trend follower’s Kryptonite is a sideways, choppy market.
In April, we had a microcosm of this with the high yield index. A choppy, sideways move in the high yield index and a brutal month end for the NASDAQ index is why our composite index underperformed the broader S&P 500 index for the month.
So let’s delve in here a bit a take a more in depth look at this Kryptonite, the sideways choppy market.
First, a reminder that trend followers generally make money when markets trend either up or down. In fact, what allows them to outperform over the longer full market cycle is the fact that they can usually make money in a bear market while broad market averages are losing money. A trend follower will usually approximate the market returns, minus the occasional head fake that costs him money, in a bull market. It is the bear market that makes this strategy work well, either alone or as a component in a diversified portfolio.
This is why we are always praying for bear markets around here! It is also why the return stream for trend followers is a bit choppy.
The most difficult market for the trend follower is the sideways market. We saw this in the broader markets in 2011, where the average trend follower trailed the market averages by an average of 7-10% as a result.
We also saw this recently in the high yield index in March/April. Check out this chart:
Can you see a pattern here? Note the majority of the month the price action was crossing above and below the moving averages during April. Please note that the moving averages are NOT our signal for high yield it is merely for demonstration purposes.
However in our example above, you will note that a buy signal is received every time the fast 10 period moving average crosses the slower 20 period moving average. Likewise a sell signal is received when the faster 10 period moving average crosses below the slower 20 perioid moving average. So in our example, we had one signal in late March and two signals in April.
Each signal causes the portfolio pain in commission costs, SEC fees and slippage. This weighs on portfolio performance unless a trend is reestablished. In our case, such trades cost the high yield strategy 138 basis points vs. just buying and holding the index in April.
These types of markets, whether short-term like the high yield average in April or longer term like in 2011, are the price you pay to avoid and make money on the big trends like in 2007-2008.
What do you think? Do you think trend following works or is the risk of being out of step with the market too high? Leave me a comment below.
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