Why are trend-followers having a good year - A rationale, not a description

Trend-followers are having a very good year with many generating double-digit gains and almost all beating a classic 60/40 stock-bond portfolio. Any investor who had trend exposure would have seen stronger performance this year as well as in 2021. Trend-followers have done what has been expected of them - strong diversification and returns during a period of market turmoil.   

Many managers have written about their strong returns this year but have focused on performance contribution - an analysis of market gains and losses. For investors, the key question is why are trend-followers doing well now? What are the characteristics of markets or the environment that now make trend-following successful? We will provide context on this question with some broad conceptual thinking and then move to some specifics.

We start with the simple investment framework that there are two types of traders or strategies, convergent and divergent. Divergent traders make money when markets move away from current equilibrium prices while convergent traders profit from prices moving back to equilibrium after some disturbance. Trend-following is a divergent strategy because it capitalizes on dislocations or tail events. It is long volatility. 

The cause for trends are clear in hindsight although not apparent in real time. Unexpected changes or surprises in fundamentals will lead to price changes. However, because changes in fundamentals are not always obvious, the process of price adjustment may take time. The market does not wake-up one day to a recession risk or a Fed change. Changes in fundamentals occur slowly one data announcement or adjustment at a time. Not all traders discount information the same way or at the same time. One investor's interpretation of an inflation report may be viewed as transitory while the next suggests persistence. Smart money thinking is not always immediate or sizable. Market beliefs evolve over time.

Trend-followers will do better when there are a sequential set of fundamental shocks generally in the same direction as opposed to a single large shock. The sequence of small shocks will lead to a sequence of price changes from which trend direction can be extracted. 

Large unanticipated shocks, big moves like March of 2020, are not always good for trend-followers if the shock is reversed quickly or the shock leads to an immediate new equilibrium where investors all agree on new valuations. If the trend-follower is wrong-footed going into the shock, loses may mount and if the shock is truly a surprise, gains are not obtained from prior price information. The trend-follower may be luckier than right. 

If information is revealed slowly through time, then prices will adjust slowly. The fact that there is disagreement on whether inflation will be transitory is good for creating price trends. If there is no agreement on price direction, the price discovery process and move to some equilibrium will take longer. The trend-follower will extract all necessary information from the slow adjustment as opposed to trying to decipher the fundamentals.

The transition of policy is another reason for trends. The slow adjustment in central bank action will lead to slower adjustment in prices. A central bank that is behind the curve is good for trends. If policy is up to date with the current environment, trends will not exist. If the central bank will make a strong immediate adjustment, prices will move but trends may not provide signals.

Trend-following needs uncertainty in markets. Trend-following needs volatility. Trend-following needs ambiguity and complexity. A lack of market clarity concerning the current and future market environment will generate slow price adjustments; an environment for the trend-follower to exploit.

Look at the current environment. The lack of consensus and clarity make for a better trend environment especially for macro markets like rates, indices, and currencies. The same applies with markets hard to value like commodities, currencies, rates, and indices. The link between inflation and markets is hard to measure. The threat of global economic slowdown is hard to discount. The price of money across two countries is difficult to forecast. The best way to track the impact of fundamental changes to price is through following the price action.

So, what kind of market environment have we had over the last year? 

• Unprecedented moves in inflation relative to the last 40 decades and little understanding of cause and effect. A divergence.
• A growing threat of recession as the Fed starts a tightening cycle. Another divergence.
• A truly uncertain geopolitical environment marked by a war that may not have an immediate winner. A market dislocation.
• Ambiguity on economic growth after a pandemic. Unprecedented.
• A high level of complexity in commodity and market logistics which create demand and supply chaos. A truly infrequent environment.

This is not an environment for the convergent mean-reverter and it is not an environment for the global fundamentalist or for the value player. Some managers and strategy may succeed, but the landscape is focused on divergences which are hard to assess given volatility, uncertainty, complexity, and ambiguity. It is an environment where the trader who follows the evolving weighted opinion of investors moving prices as trends will have a greater chance for success. The focus on performance analysis may be on where money was made, but it all starts with a divergent environment.