An economist at the Bank of England, Andy Haldane has conducted a simple experiment that gets across the essence of trend-following. Imagine an investment strategy in US stocks based entirely on the past direction of the stock market. If the market rises during the prior period, the strategy buys stocks for the next period. If the market falls during the prior period, the strategy sells. The strategy simply extrapolates the most recent market trend. If you had started this process in 1880 with $1, shifting in and out of the stock market in response to the market’s prevailing trend, you would now have over $50,000.
Alternatively, you could have pursued a crude value strategy instead. This strategy assesses whether the market is undervalued or overvalued and buys only when value gives a positive signal. The criterion for assessing value is Robert Shiller’s dividend discount model. We like Shiller, but this crude value strategy is not particularly compelling in Haldane’s experiment. If you had started in 1880 with $1, you would now have 11 cents.
But focusing on the stock market in isolation is missing the point. Trend-followers, unlike most fund managers, are not myopically focused on the stock market to the exclusion of all other financial assets. They scour other markets for trends, too: interest rates; currencies; commodities; metals. And unlike most fund managers, they are just as content to sell the market as they are to buy it. Which is why the correlation of most trend-following funds to traditional markets like those for stocks and bonds is more or less zero.