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Better times right around the corner for Trend Following Systems

April 4, 2005

 

With 4 out of 5 trend following systems we track seeing double digit losses of between -10% and -15% in the first quarter, the beginning of 2005 is starting to look an awful lot like the middle of 2004, and that has a lot of trend following investors worried.

The middle of 2004 saw the trend following universe trying to survive some tough times. Famous trend following managed futures programs, or CTAs (Commodity Trading Advisors), with billions of dollars under management such as John W. Henry, Niederhoffer, Campbell &Co., and Dunn Capital were down anywhere between 5% to 40% on the year - with many seeing multiple losing months in a row.

The CSFB/ Tremont Managed Futures Index, meanwhile, was down -6.99% through the end of August 2004, and had seen six straight months of losses, the longest such streak since its inception in 1994.

So here we are in 2005, and trend following is starting to look lackluster again. Most of the CTA managers and trend following system developers we've talked to say this is just one of those non-trending environments where trend followers won't do well.

BUT the news has been flooded with stories of record high Crude Oil prices, a historically weak US dollar, and new highs commodity indexes like the CRB based on China's insatiable appetite for natural resources. If all these trends are going on, why aren't the trend following systems taking advantage?

Well, my quick advice is: "don't believe everything you see on CNBC". Take the grain markets, for example, the recent up trend there came on the heels of 10+ month down trend, yet the news would have you believe all commodity prices have been trending upwards like mad due to the Chinese. Likewise, stories of the falling US dollar are still in the news today, despite the fact that the dollar has rallied neatly off its lows.

The more involved answer is that many of the current trends we are seeing (Energies UP, Bonds DOWN, Dollar UP (foreign currencies down), and Grains UP are very tricky trends sharing some common characteristics. These trends are:

1. Quick trends whose direction is counter to rather long trends that immediately preceded them
2. Trends not being confirmed by the long term Rate of Change indicator
3. Trends not being confirmed by the ADX trend indicator

We highlighted the US Dollar Index, 10 Yr Note, Crude Oil, and Soybean markets in the charts below, as those four are good proxies for the movements of the currency, interest rates, energy, and grain sectors. We added the ADX and ROC indicators to show there is more to a trend than just rising and falling prices, and also added some very basic red and blue trend lines to the charts.

The trendlines show that the current trends are all very small in magnitude and length of time compared to the trends immediately preceding them, and that they are all in the opposite direction of the rather lengthy trends that immediately preceded them. Trend followers usually catch trends emerging from a directionless, choppy environment - not an environment where the new trend is exactly opposite of the preceding one.

The ADX stands for the average directional index, and measures the "consistency" of the trend. A trend that gradually moves in one direction over a lengthy period of time will have a high ADX reading. Conversely, a quick 1-2 month trend up followed by a quick trend down, and so on will produce a lower ADX reading.

Looking at the charts below, we can see that the ADX was sideways or sloping down in the May to August 2004 period and that the ADX made swing highs (circled in yellow) in December of 2004 when trend followers were finishing off a very good 4th quarter. Despite somewhat recent ADX high points in the 10 Yr, Crude Oil, and Soybeans, the ADX indicator has started to slope downwards again, meaning we could already be in the directionless environment trend following systems bracket in hopes of a "break-out" to new highs or lows.

The ROC measures the rate of change, and we used a 100 day ROC in the charts below to see whether the trends were being confirmed by the overall, long term direction of the market. It is generally not a good idea to "fight" the overall direction of the market, thus going long when the ROC is negative and vice versa, but there is the potential for profits in getting into a reversal trend while waiting for the lagging ROC indicator to catch up and realize the old trend has ended.

Looking at the charts below, we can see that the ROC indicator was choppy, moving from positive to negative and so on in the May to August 2004 period for each market (with the exception of Crude Oil), and that each market is starting to show a choppy 100 day ROC again in the first quarter of 2005. This is telling us that despite what we hear on the news and despite what we see on the chart, many of these sectors do not have a distinct long term direction. This is obviously a bad thing for systems designed to capture the long term trends in markets, but there is a silver lining.

After reviewing the following charts, it does appear that we are in a market environment very similar to the one experienced in the middle of 2004.....and we should be so lucky. The last four months of 2004 were very good for trend followers, with the aforementioned CSFB Managed Futures Index posting four straight profitable months while gaining over 13% and trend following systems at Attain posting impressive gains to become the best performing system group of the year. So if this is a similar environment to the middle of 2004, with new trends about to form out of somewhat directionless conditions, you don't want to be sitting on the sidelines.

- Jeff Malec