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Summary­

• While trend following may help investors avoid prolonged drawdowns, it is susceptible to whipsaw where false signals cause investors to either buy high and sell low (realizing losses) or sell low and buy high (a missed opportunity).
• Empirical evidence suggests that using economic data in the United States as a filter of when to employ trend-following – a “growth-trend timing” model – has historically been fruitful.
• When evaluated in other countries, growth-trend timing has been historically successful in mitigating whipsaw losses without sacrificing the ability to avoid large drawdowns. However, we see mixed results on whether this actually improves upon naïve trend-following.
• We find that countries that can be influenced by factors originating outside of their borders might not benefit from an introspective economic signal.

We apologize in advance, as this commentary will be fairly graph- and table-heavy.

We have written fairly extensively on the topic of factor-timing in the past, and much of the success has been proven to be both hard to implement and recreate out of sample.

One of the inherent pains of trend following is the existence of whipsaws, or more precisely, the misidentification of perceived market trends, which turn out to be more noise than signal. An article from Philosophical Economics proposed using several economic indicators to tune down the noise that might affect price-driven signals such as trend following.  Generally, this strategy imposed an overlay that turned trend following “on” when the change in the economic indicators were negative year-over-year signaling a higher likelihood of recession, and conversely, adopted a buy-and-hold stance when the economic indicators were not flashing warning lights.

This strategy presents a certain appeal as leading economic indicators may, as their name implies, lead the market for some time until capital preservation is warranted.  Switching to a trend-following approach may allow a strategy to continue to participate in market appreciation while it lasts.  On the other hand, using economic confirmation as a filter may help a strategy avoid the whipsaw costs generated from noisy market dips while positive economic conditions persist.

In an effort to test such a strategy out-of-sample, we took the approach global, hoping to capture a broader cross-section of economic and market environments.

First, we will consider trend following with no timing using the economic indicators.¹

Below we plot the equity curves for Australia, Germany, Italy, Japan, Singapore, the United Kingdom, and the United States, alongside a strategy that is long the market when the market is above the trailing twelve-month average (“12 Month average”) and steps to cash when the price is below it.  The ratio between the two is also included to show the relative cumulative performance between the trend strategy and the respective market. An increasing ratio means that the trend following strategy is adding value over buy-and-hold.

Source: MSCI, Global Financial Data.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Through the graphs above, it becomes clear that much of the trend premium is realized by avoiding the large, prolonged bear markets that tend to occur during economic distress.  In between these periods, however, the trend strategy lags the market. It makes sense, then, that a potential improvement to this strategy would be to implement an augmentation that could better distinguish between real price break-outs and those that lead to a whipsaw in the portfolio.

Growth-Trend Timing

For each country, we look at a number of economic indicators, including: corporate earnings growth, employment, housing starts, industrial production, and retail sales growth.²  The strategy then followed the same rules as described above: if the economic indicator in question displays a negative percentage change over the previous twelve-month period, a position is taken in a trend following strategy utilizing a twelve-month moving average signal.  Otherwise, a buy-and-hold position is established.

To ensure that we are not benefitting from look-ahead bias, a lag of three months was imposed on each of the economic indicators, as it would be unrealistic to assume that the economic levels would be known at the end of each month.

Unfortunately, some of the economic data points could not be found for the entire period in which prices are available, though the analysis can still prove beneficial by indicating what economic regimes trend following is benefitted by growth-trend timing, or the potential identification where one indicator may work when another does not.³

In the charts below, we plot the growth-trend timing (referred to as GTT for the remainder of this commentary) for each country utilizing the available signals. The charts represent the relative cumulative performance over the respective country’s market return.  For example, when the lines remain flat, the GTT approach has adopted buy-and-hold exposure and therefore matches the respective market’s returns. Any changes in the ratios are due to the GTT strategy investing in the trend following strategy.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

What we see from the above figures is a mixed bag of results.

The overlay of economic indicators was by far successful in the mitigation of whipsaw losses, as each country reaped the benefits of being primarily long the market during bull markets. As the 12-month moving average strategy tended to slowly give up a portion of the gains realized from severe market environments, the majority of the GTT strategies remained relatively stagnant until the next major correction.

There are some instances, however, where the indicator was late to the economic party.  It is worth remembering that the market is, in theory, a forward-looking measure, and therefore sudden economic shocks may not be captured in economic data as quickly as it is in market returns.  This created cases where the strategy either missed the chance to be out of the market during a correction or was sitting on the sidelines during the subsequent recoveries. Notably, the employment signal in Australia, Italy, Singapore, and the United Kingdom tended to be a poor leading indicator as the strategy tended to be invested longer in the bear markets than the trend strategy.

A Candidate for Ensembling

The implicit assumption in the analysis above is that the included indicators behave in similar ways.  For example, by using a twelve-month lookback period for the indicators, we are assuming that each indicator will begin to trend in roughly the same way.

That may not be a particularly fair assumption.  Whereas housing starts and retail sales are generally considered leading indicators, employment (unemployment) rates are normally categorized as lagging indicators. For this reason, it may be more beneficial to use a shorter lookback period so as to pick up on potential problems in the economy as they begin to present themselves.  Further, some signals tend to be more erratic than others, suggesting that a meaningful lookback period for one indicator may not be meaningful for another. With no perfect reason to prefer one lookback over another, we might consider different lookback periods so as to diversify any specification risk that may exist within the strategy.

With the benefit of hindsight, we know that not all recessions occur for the same reasons, so being reliant on one signal that has worked in the past may not be as beneficial in the future. With this in mind, we should consider that all indicators hold some information as to the state of the economy since one indicator may be signaling the all-clear while another may be flashing warning lights.

For the same reason medical professionals take multiple readings to gain insight into the state of the body, we should also consider any available signals to ascertain the health of the economy.

To ensemble this strategy, we will vary the lookbacks from six to eighteen months, while holding the lag at three months, as well as combine the available economic signals for each country.  For the sake of brevity, we will hold the trend-following strategy the same with a twelve-month moving average.

Remember, if the economic signal is negative, it does not mean that we are immediately out of the market: a negative economic signal simply moves the strategy into a trend-following approach. With 5 economic indicators and 13 lookback periods, we have 65 possible strategies for each country. As an example, if 40 of these 65 models were positive and 25 were negative, we would hold 62% in the market and 38% in the trend following strategy.

The resulting performance statistics can be seen in the table below.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

From the table above, we see that there are, again, mixed results. One country that particularly stands out is Italy in that the sign on its return flipped to negative and the drawdown was actually deeper with GTT than with a simple buy-and-hold strategy.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Digging deeper, it appears that the GTT strategy for Italy was actually whipsawed by more than just trend-following. Housing start data for Italy was not readily available until December 2008, so Italy may have been at a relative disadvantage when compared against the other countries.  Since the reliable data we could find begins at the end of 2008 and the majority of the whipsaw losses occur post-Great Financial Crisis, we can run the analysis again, but with housing start data being added in upon its availability.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Adding housing starts in as an indicator did not meaningfully alter the results over the period. One hypothesis is that the indicators included could not fully encapsulate the complex state of Italy’s economy over the period.  Italy has weathered three technical recessions over the past decade, so this could be a regime where the market is looking to sources outside the country for indications of distress or where the economic indicator is not reflective of the pressures driving the market.

Source: MSCI, St. Louis Fed.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Above, we can see several divergences between the market movement and changes in real GDP. Specifically, in the past decade, we see that the market reacted to information that didn’t materialize in the country’s real GDP. More likely, the market was reacting to regional financial distress driven by debt concerns.

The MSCI Italy index is currently composed of 24 constituents with multinational business operations. Additionally, the index maintains large concentrations in financials, utilities, and energy: 33%, 25%, and 14%, respectively.⁴  Because of this sector concentration, utilizing the economic indicators may overly focus on the economic health of Italy while ignoring external factors such as energy prices or broader financial distress that could be swaying the market needle.

A parallel explanation could be that the Eurozone is entangled enough that signals could be interfering with each other between countries. Further research could seek to disaggregate signals between the Eurozone and the member-countries, attempting to differentiate between zone, regional, and country signals to ascertain further meaning.

Additionally, economic indicators are influenced by both the private and public sector so this could represent a disconnect between public company health and private company health.

Conclusion

In this commentary, we sought to answer the question, “can we improve trend-following by drawing information from a country’s economy”. It intuitively makes sense that an investor would generally opt for remaining in the market unless there are systemic issues that may lead to market distress.  A strategy that successfully differentiates between market choppiness and periods of potential recession would drastically mitigate any losses incurred from whipsaw, thereby capturing a majority of the equity premium as well as the trend premium.

We find that growth-trend timing has been relatively successful in countries such as the United States, Germany, and Japan.  However, the country that is being analyzed should be considered in light of their specific circumstances.

Peeking under the hood of Italy, it becomes clear that market movements may be influenced by more than a country’s implicit economic health.  In such a case, we should pause and ask ourselves whether a macroeconomic indicator is truly reflective of that country’s economy or if there are other market forces pulling the strings.

This post is available for download here.

Summary

• While it may be tempting to time allocations to active strategies, it is generally best to hold them as long-term allocations.
• Despite this, some research has shown that there may be certain economic environments where trend following equity strategies are better suited.
• In this commentary, we replicate this data and find that a broad filter of recessionary periods does indeed show this for certain trend equity strategies but not for the style of trend equity in general.
• However, further decomposing the business cycle into contractions, recoveries, expansions, and slowdowns using leading economic indicators such as PMI and unemployment does show some promising relationships between the forecasted stage of the business cycle and trend following’s performance relative to buy-and-hold equities.
• Even if this data is not used to time trend equity strategies, it can be beneficial to investors for setting expectations and providing insight into performance differences.

Systematic active investing strategies are a way to achieve alternative return profiles that are not necessarily present when pursuing standard asset allocation and may therefore play an important role in developing well-diversified portfolios.

But these strategies are best viewed as allocations rather than trades.¹ This is a topic we’ve written about a number of times with respect to factor investing over the past several years, citing the importance of weathering short-term pain for long-term gains. For active strategies to outperform, some underperformance is necessary. Or, as we like to say, “no pain, no premium.”

That being said, being tactical in our allocations to active strategies may have some value in certain cases. In one sense, we can view the multi-layered active decisions simply as another active strategy, distinct from the initial one.

An interesting post on Philosophical Economics looked at using a variety of recession indicators (unemployment, earnings growth, industrial production, etc.) as ways to systematically invest in either U.S. equities or a trend following strategy on U.S. equities. If the economic indicator was in a favorable trend, the strategy was 100% invested in equities. If the economic indicator was in an unfavorable trend, the strategy was invested in a trend following strategy applied to equities, holding cash when the market was in a downtrend.

The reasoning behind this strategy is intuitively appealing. Even if a recession indicator flags a likely recession, the market may still have room to run before turning south and warranting capital protection. On the other hand, when the recession indicator was favorable, purely investing in equities avoids some of the whipsaw costs that are inherent in trend following strategies.

In this commentary, we will first look at the general style of trend equity in the context of recessionary and non-recessionary periods and then get a bit more granular to see when trend following has worked historically through the economic cycle of Expansion, Slowdown, Contraction, and Recovery.

Replicating the Data

To get our bearings, we will first attempt to replicate some of the data from the Philosophical Economics post using only the classifications of “recession” and “not-recession”.

Keeping in line with the Philosophical Economics method, we will use whether the economic metric is above or below its 12-month moving average as the recession signal for the next month. We will use market data from the Kenneth French Data Library for the total U.S. stock market returns and the risk-free rate as the cash rate in the equity trend following model.

The following table shows the results of the trend following timing models using the United States ISM Purchasing Managers Index (PMI) and the Unemployment Rate as indicators.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

With the trend timing model, we see an improvement in the absolute returns compared to the trend equity strategy alone. However, this comes at the expense of increasing the volatility and maximum drawdown.

In the case of unemployment, which was the strongest indicator that Philosophical Economics found, there is an improvement in risk-adjusted returns in the timing model.

Still, while there is a benefit, it may not be robust.

If we remove the dependence of the trend following model on a single metric or lookback parameter, the benefit of the macro-timing decreases. Specifically, if we replace our simple 12-month moving average trend equity rule with the ensemble approach utilized in the Newfound Trend Equity Index, we see very different results. This may indicate that one specific variant of trend following did well in this overall model, but the style of trend following might not lend itself well to this application.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

A more robust trend following model may already provide more upside capture during non-recessionary periods but at the expense of more downside capture during recessions. However, we cannot confidently assert that the lower level of down-capture in the single specification of the trend model is not partially due to luck.

If we desire to more thoroughly evaluate the style of trend following, we must get more granular with the economic cycles.

Breaking Down the Economic Cycle

Moving beyond the simple classification of “recession” and “not-recession”, we can follow MSCI’s methodology, which we used here previously, to classify the economic cycle into four primary states: Expansion, Slowdown, Contraction and Recovery.

We will focus on the 3-month moving average (“MA”) minus the 12-month MA for each indicator we examine according to the decision tree below. In the tree, we use the terms better or worse since lower unemployment rate and higher PMI values signal a stronger economy.

There is a decent amount of difference in the classifications using these two indicators, with the unemployment indicator signaling more frequent expansions and slowdowns. This should be taken as evidence that economic regimes are difficult to predict.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

Once each indicator is in each state the transition probabilities are relatively close.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Past performance is not an indicator of future results.

This agrees with intuition when we consider the cyclical nature of these economic metrics. While not a perfect mathematical relationship, these states generally unfold sequentially without jumps from contractions to expansions or vice versa.

Trend Following in the Economic Cycle

Applying the four-part classification to the economic cycle shows where trend equity outperformed.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

During contraction phases, regardless of indicators, trend equity outperformed buy-and-hold.

For the PMI indicator, trend equity was able to keep up during expansions, but this was not the case with the unemployment indicator. The reverse of this was true for recoveries: trend following was close to keeping up in the periods denoted by the unemployment indicator but not by the PMI indicator.

For both indicators, trend following underperformed during slowdowns.

This may seem contradictory at first, but these may be periods of more whipsaw as markets try to forecast future states. And since slowdowns typically occur after expansions and before contractions (at least in the idealized model), we may have to bear more of this whipsaw risk for the strategy to be adaptable enough to add value during the contraction.

The following two charts show the longest historical slowdowns for each indicator: the PMI indicator was for 11 months in late 2009 through much of 2010 and the unemployment rate indicator was for 16 months in 1984-85.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index.

In the first slowdown period, the trend equity strategy rode in tandem with equities as they continued to climb and then de-risked when equities declined. Equities quickly rebounded leaving the trend equity strategy underexposed to the rally.

In the second slowdown period, the trend equity strategy was heavily defensive going into the slowdown. This protected capital initially but then caused the strategy to lag once the market began to increase steadily.

The first period illustrates a time when the trend equity strategy was ready to adapt to changing market conditions and was unfortunately whipsawed. The second period illustrates a time when the trend equity strategy was already adapted to a supposedly oncoming contraction that did not materialize.

Using these historical patterns of performance, we can now explore how a strategy that systematically allocates to trend equity strategies might be constructed.

Timing Trend Following with the Economic Cycle

One simple way to apply a systematic timing strategy for shifting between equities and trend following is to only invest in equities when a slowdown is signaled.

The charts below show the returns and risk metrics for models using the PMI and unemployment rate individually and a model that blends the two allocations.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

The returns increased slightly in every model relative to buy-and-hold, and the blended model performed consistently high across all metrics.

Blending multiple models generally produces benefits like these shown here, and in an actual implementation, utilizing additional economic indicators may make the strategy even more robust. There may be other ways to boost performance across the economic cycle, and we will explore these ideas in future research.

Conclusion

Should investors rotate in and out of active strategies?

Not in most cases, since the typical drivers are short-term underperformance that is a necessary component of active strategies.

However, there may be opportunities to make allocation tweaks based on the economic cycle.

The historical data suggests that a specification-neutral trend-equity strategy has outperformed buy-and-hold equities during economic contractions for both economic indicators. The performance during recoveries and expansions was mixed across indicators. It kept up with the buy-and-hold strategy during expansions denoted by PMI but not unemployment. This relationship was reversed for recoveries denoted by unemployment. In both models, trend equity has also lagged during economic slowdowns as whipsaw becomes more prevalent.

Based on the most recent PMI data, the current cycle is a contraction, indicating a favorable environment for trend equity under both cycle indicators. However, we should note that December 2018 through March 2019 was also labeled as a contraction according to PMI. Not all models are perfect.

Nevertheless, there may be some evidence that trend following can provide differentiated benefits based on the prevailing economic environment.

While an investor may not use this knowledge to shift around allocations to active trend following strategies, it can still provide insight into performance difference relative to buy-and-hold and set expectations going forward.