Talking Semantics – It’s all Price Following

To the passive investment manager with a buy and hold position in the S&P500 who shakes his fist at the Trend/Momentum Follower and declares “I told you so…..Buy and Hold is the only way”..perhaps it is just an illusion of perspective.

After all, the S&P500 itself being an index is a trend following system that buys high (enters index) and sells low (leaves index), not in terms of simply price but rather market capitalisation (which incorporates price and number of shares into its calculation). You say this buy and hold method is unlike trend following because it has no exit condition. Think again. The stop exits are when that company leaves the index. The S&P500 only differs in it’s stop placement to other trend/following momentum methods by virtue of its very wide exit condition…hence the volatility of buy and hold over the long term.

Let’s be clear here, market capitalisation is all about price and should not be confused with a notion of ‘perceived value’. It may be different……but a central takeout here is that ‘price is always right’.

I truly feel for the equity investors with their diversified portfolios who cannot mirror the index…..but if only they knew the secret. The index was a trend following system all along, a system that us trend followers and momentum chasers know very well indeed….but has it’s limitations in being long only and subject to possible very adverse volatility if the Index fails to rise over the long term in a declining economy. No wonder divergent traders with a broad diversified portfolio that trade both long and short have lower risk weighted returns. You don’t have to be a rocket scientist to understand that nuance.

Why does the index rise over time?…..well there is a selection bias at play here as we are using a rotational trend/momentum following strategy in the broader context of a growing economy. Those companies that fail, slip off the index as their market cap declines with new emergent companies taking their place and filling the gaps to be the top 500 companies at all times. But what happens in those times when an economy falters and declines. We will still have an S&P500 but the composite is not guaranteed to rise for ever and a day. Just take other indexes like the Nikkei for example… teach you a lesson in the 30 year economic fallacy…….and what about civilizations in general. What does history teach us? Perhaps we need to consider short positions as well to check our economic hubris? Just look at the chart below. Do you see trends both long and short….but supposedly trends are no more…*scratches head again*. Perhaps longer timeframes for trend following are still useful?

Nikkei Index 1950 – Current

So now we understand that principle, let’s see if we can do better than a long only market cap rotational system solution…….and yes we can. We have been trying to tell you all this for a very long time.

The way we do this is by using a longer term rotational system that adopts risk-weighted returns as it’s selection principle and trades both long and short as markets go up and down. We can’t assume it’s up forever. We are less hopeful than that. We furthermore extend our universe far more broadly than equities alone as we are aware that correlations change and during some adverse conditions, equities can become very correlated.

Our very diverse universe of return streams are ranked in terms of their risk weighting using the very powerful and useful MAR ratio. This ratio is a far better risk-weighted measure than say the Sharpe ratio as  we avoid any propensity to apply those measures that reflect a hypothetical Gaussian distribution. We know the real financial markets are not that simple. In the world of fat tails, such risk weighted measures break down and have limited use.  .

So given we like to diversify very broadly,  let’s apply a similar top 500 in terms of risk-weighted returns in a far broader universe of return streams. Like the S&P500 Index our rotational risk-weighted index (called a portfolio) is continuously recalculated where that top 500 regularly changes it’s composition….however over time we find a very curious feature. The composition slowly starts to become more constant over time as the chaff is filtered from the collection. We find that that the return streams stabilise. Those return streams that endure large drawdowns relative to their rates of return are naturally filtered from the list leaving the more robust survivors in the limited population of 500.

Does it sound a bit like natural selection at work?

In a world full of risk, where you can frequently be wrong you need a systems guiding hand to keep you on track that continuously and unemotionally assesses the state of the market.  Do you know what kills you? Being wrong all the time. A unidirectional strategy working on the assumption that it is always ever upward will kill you. A bi-directional diversified strategy that measures the environment constantly and attempts to shadow price will never kill you. It may hurt you in it’s delayed response time…but in surviving you are given an olive branch by the market and a chance to adapt to the new condition before it kills you.

Is a bi-directional strategy flexible enough to cope with adaptive markets? You only really need to look at life to answer that one.

Trade well and prosper

Rich B

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