When I was a young account executive with Merrill Lynch in
the mid-1970's, I became friendly with the top producer in our office. One day
he shared with me one of the secrets of his success – he would only promote
stocks based on what percentage of Dow Jones Industrial stocks were below their 39-week
moving averages. Few investors knew what moving averages were back then, and there were no PCs for calculating them.
So I dug up all the old stock charts I could find with moving averages on them and
verified that this moving average filter was incredibly useful. Not long after
that, I was accepted into the PhD programs at both the University of Chicago
and Wharton. I turned them both down, based in part on the how well this moving
average method had done. (I was also impressed with Bob Levy's research on
relative strength momentum and the Nick Darvas book describing his remarkable
success using rotational momentum.) The efficient market hypothesis, which said
the market could not be beat using publicly available information, was akin
to religion in the academic world at that time. I had frightening visions of
being burned at the stake in the University of Chicago quadrangle if I had gone
there.
Wednesday, December 12, 2012
Trend Following
3:52 PM
Gary Antonacci
Things have certainly changed since then. During the past 20
years, academics have found strong evidence of profitability using trend following
methods, such as moving averages. As with momentum, behavioral finance is what led
to serious trend following research by the academic community. A large body of
research now shows that price trends exist in part due to long-standing
behavioral biases by investors, such as anchoring and hoarding. Price trends
are created when investors initially under-react and subsequently over-react to
information because of strongly ingrained behavioral tendencies.
There are now over a dozen well-researched academic papers documenting
extraordinary risk-adjusted returns from trend following methods. Here are three excellent, recently released papers
on the subject of trend following:
Market Timing with Moving Averages by Paskalis Glabadanis
A Century of Evidence on Trend-Following Investing by Brian Hurst, Yao Hua Ooi, and Lasse H. Pedersen
The first two papers deal with moving averages
applied to U.S. stocks. The third is a simple white paper from the folks at AQR. It features time series (absolute) momentum
applied to 59 markets in 4 asset classes: equity indices, bonds, commodities,
and currency pairs. The authors use a weighted combination of 1, 3, and 12
month look back periods on data going back to 1903. Their paper
provides convincing evidence that trend following absolute momentum is just as
robust and pervasive as cross-sectional relative strength momentum.
The expanded version of my paper, Risk Premia Harvesting Through Dual Momentum, shows that absolute momentum is actually more
valuable than relative strength momentum. Both enhance returns, but absolute
momentum is more effective in reducing expected volatility and drawdown. The best
of all worlds is to use them both together.
