The Trouble With Trend Following

January 21, 2010

Trend following works until it doesn’t, and the current rally is looking a little long in the tooth.

The longer a market trend is in place the more dangerous it becomes, and this extraordinary rally encompassing a variety of asset classes is no exception. Following the trend is profitable and comfortingly reassuring, right up to the point of maximum risk.

KentGrealish_Column

Simplistic as it may sound, as asset values soar, the potential for future profits diminish and the risks increase. So it would seem that the more pragmatic approach from a risk/reward perspective would be to progressively sell into an extended rally and incrementally scale back exposure to a serious correction.

The problem is that while this strategy would certainly reduce market risk, it would increase opportunity risk accordingly and, more significantly, raise the odds of regret should the rally continue. It is said that when asked how his family had accumulated such enormous wealth, Baron Rothschild responded, “We always sold too soon.” For the rest of us, selling too soon can be an excruciatingly painful experience.

A disciplined asset allocation strategy can solve this problem. Any dramatic increase in the value of an asset class will throw the allocation out of equilibrium and require selling a portion of the appreciated asset to bring the portfolio back into balance. This overrides the emotional element in the decision-making process, which not only makes the strategy easier to implement, but mitigates the natural inclination to second-guess ourselves if we sell “too soon.”

A more popular alternative is to become a “fully invested bear.” We are currently witnessing the apparent paradox of reputable market strategists who remain fully invested in the belief that the current rally still has some life left in it yet admit that they expect things to “end badly.”

What does this imply about their strategy? Clearly they want to fully exploit whatever is left of this rally. But then what? The two most likely assumptions are: (1) when the market eventually corrects, they expect to be caught fully invested and pay the consequences, or (2) they expect to “know” when to sell and ultimately avoid any serious losses. Since it is improbable that any strategist worth his salt would accept option (1), they must expect to receive some signal indicating when the market has peaked and it is time to sell.

Despite the fact that history suggests this to be a highly unlikely outcome, it is certainly a consistently held belief among the investors and advisers I have known over my 36 years in this business. In fact, for a significant fraction of that time, I felt the same way.

Bitter experience taught me the truth of the old Wall Street saying—“nobody rings a bell at the top of the market.” Nevertheless it sure seems like a lot of people are anxiously awaiting the arrival of Quasimodo, the bell-ringing Hunchback of Notre Dame. Most, if not all of them, are sure to be disappointed because this is a policy based more on hope than facts—and hope is a not a strategy.


Kent Grealish is a partner at Quacera Capital Management, a fee-only advisory firm. He welcomes comments and suggestions for future columns at:

[email protected]

.


 

Find your next ETF

Reset All