When Trend is Your Friend

“The trend is your friend” is an old market adage known by traders old and new alike. Other sayings like “take what the market gives you” and “don’t fight the tape” share a similar underlying principle that forms the basis for investing approaches like “momentum” and “trend-following” strategies. The principal is simple, markets typically move in trends and it typically doesn’t pay to move against an existing one, at least in the short term.

Much research has been done on this topic, a seminal study was published in 1993 by Jagadeesh and Titman at UCLA. And while empirical research has revealed the presence of price trends and momentum, there is no definitive reason for why the phenomena exist. Explanations often end in the abstract fringes of investor psychology. Simply put, it seems like people just like to buy winners and sell losers!

Moving mouse and monkey lines

Regardless of research or reasons, we can observe past price trends by using a basic moving average framework. The chart below shows S&P 500 prices from January 1, 1990, to November 27, 2023, shown in black. The red and blue lines show two simple moving average (SMA) price lines. The red line is a “shorter-term” average that uses 50 days (about ~3 months), and the blue line is a “longer-term” average that uses 200 days (~10 months).

S&P 500 Price

The 2 SMA lines form a simple signal for identifying trends. Specifically when the red SMA (short-term) crosses below the blue SMA (long-term), that signals a downtrend. Likewise, when the red SMA crosses above the blue SMA, that signals an uptrend. There is no secret to the signal. The two SMA lines compare the difference between short-term and long-term price trends. When short-term prices move higher than long-term, that reflects an uptrend and vice versa.

For example, look at point A in 2000. After the red line crosses below the blue line, the S&P (black line) trends down until 2002. At point B (2002) the red line crosses above the blue line and the S&P trends upwards until point C (2008) when it reverts back down until point D (2009) when it reverses back up. This same pattern can be observed throughout market history where crosses of the SMA lines signal trend changes in price.

Moving averages are some of the most basic and simple techniques that technical analysts use. So simple and basic that “serious investors” often deride the techniques as being too “Mickey Mouse” or “monkey-like” to actually work. In the defense of monkeys, studies have shown that monkeys throwing darts at lists of stocks can outperform most professional stock-pickers!

The point is the simplicity of an approach is not a good way to evaluate its efficacy. The reality is a simple approach using 50-day/200-day SMA signals (buy on uptrends and sell on downtrends) would have outperformed the S&P 500 over the last 20 years thereby outperforming most investors who notoriously fail to “beat the market.”

Real-world implications

Mickey Mouse and monkeys aside, how does this work in the real world? Does an SMA approach always beat the market, can it? No, on both counts. And of course not, there is no such thing as a strategy that always works or wins. It depends on the period, how the signals are interpreted, the cadence of transactions, and many other details. Suffice it to say that simple is not the same as easy, and making an SMA strategy work well is definitely easier said than done.

Still, we can make use of SMA signals as one indicator (among others) to glean insight into market conditions. Zooming into the last two years, S&P SMA lines signaled a downtrend in 2022 but crossed into an uptrend in 2023. The pullback from August to October threatened a trend reversal, however, the short-term SMA managed to stay above the long-term and appears to be holding the uptrend. This, on its own, is a positive signal for stocks and other risk assets.

S&P 500 Price

As always, any signal or indicator can be wrong. Look back far enough and we’ll find many SMA false signals. Hindsight is 20/20, but signals get blurry up close because it’s difficult to know in real-time if a signal is genuine or just another head fake (again, implementation is easier said than done). In addition, even as price trends improve, other market signals like narrow breadth imply less strength than headlines show.

There is always uncertainty, so it helps to look at other indicators and more than just market signals. I’ve been writing for months about fluctuating economic data. For example, last year there was fear that declining U.S. corporate profits would get worse in 2023. However, profits bounced and are reaccelerating.

U.S. Corporate Profits

Business activity, as measured by U.S. Composite PMI readings, has also managed to stay above the crucial 50-level (above 50 indicates expansion) with three improving readings in a row. The improvements were modest, but the “higher low” in August (versus December 2022) is constructive, and further improvement could indicate an uptrend forming.

S&P Global U.S. Composite PMI

Of course, uncertainties remain. There are still some divergent indicators. For example, interest rates and manufacturing data still flash recessionary. And even as other data points improve, what constitutes a definitive uptrend? Are three readings enough, or do we need more? There is no clear answer, but based on experience any one or two readings could easily be attributed to random noise.

We want to see at least three consecutive readings to have any confidence in a trend, and of course, more is better. That brings us to the most compelling economic indicator right now. The OECD U.S. Composite Leading Indicator combines a range of different economic data into a single measure (the CLI). As of October 2023, the CLI has registered 7 increasing readings in a row.

OECD U.S. Composite Leading Indicator

It could be a coincidence or noise, but it’s more likely that seven consecutive improvements signal an uptrend. Looking back, critics point out that the CLI also posted 23 consecutive declines between 2021 and 2023 with no recession. That is true, but to be fair, both economic and market conditions were negative throughout 2022.

The bottom line

In summary, there continues to be uncertainty and divergence in economic and market conditions. However, overall and on the margin it’s fair to say that conditions are better now than they were at the beginning of the year.

The combination of improving market and economic data implies a favorable outlook for risk assets like stocks in the near term. As such we will continue to increase our risk allocation in our Macro Allocation strategy. More specifically, we move from modest underweight up to a neutral weight of risk assets and intend to enter 2024 at our strategic risk targets.

Of course, timing is always a challenge. Although the trend is our friend for now, it will only be so until it isn’t. We don’t know when that will happen, but we do know markets and data will change. Meanwhile, we will be watching closely and also taking what the market is giving us. In addition, we’ll do our best not to fight the tape, the Fed, or monkeys we cannot beat.

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Victor K. Lai, CFA