Case: Trend-Following Through 2008 and 2022

Crisis alpha: what trend-following is paid for

Trend-following earns its keep in a particular kind of market: one where moves persist for months across many assets. The worst equity drawdowns tend to be exactly that. A crisis is rarely a single bad day; it is a slow repricing — of credit, of growth, of rates — that unfolds over months as information arrives and leverage is unwound. A rule that sells after a trend breaks is out for most of that. Hurst, Ooi and Pedersen tested simple trend rules across equity indexes, bonds, currencies and commodities back to 1880 and found positive average returns in every decade, with notably good results during the largest drawdowns of a traditional 60/40 portfolio. Practitioners call this behaviour “crisis alpha”. It is not magic and not guaranteed: it depends on the crisis being persistent, and it is earned by a diversified rule trading many markets, not by a single equity index in isolation. Diversification is the part most people miss. In 2008 a trend-follower was not only short or out of equities; it was typically long government bonds as yields fell, long the U.S. dollar, and short commodities as they collapsed. Several persistent moves at once is what a crisis looks like to a trend rule. 2008, as a trend rule saw it — Equities: S&P 500 total return −37.0% — a persistent decline · Government bonds: Yields fell as investors sought safety — a persistent rally · U.S. dollar: Rose in the scramble for dollar funding · Commodities: Oil fell from over $140 in July to under $40 by December ←

2008 through one plain rule

Strip trend-following down to one market and one rule and the behaviour is easier to see. The rule in this lesson’s replay owns SPY while it closed above its 200-day average the day before, and holds cash otherwise. It is deliberately simple: no stop, no target, one parameter chosen because 200 sessions approximates a trading year. The S&P 500 closed below its 200-day average in November 2007 and, apart from brief rallies, stayed below it, so the rule spent most of 2008 in cash. It traded back in briefly during bear-market rallies — the whipsaws — and stayed out through the autumn crash and the March 2009 low. It bought back at the end of May 2009, more than a third above that low. The replay computes what that path was worth against buy-and-hold over the same months, on real closing prices. Read the result as a profile, not a recommendation. The rule did not need to know about Lehman Brothers, credit spreads or the Fed; it needed the decline to persist, and it did. In a crash that reverses in weeks — October 1987, or March 2020 — the same rule sells near the bottom and buys back higher, and loses on the round trip. • Out: a close below the 200-day average in November 2007. • Whipsaws: brief re-entries during bear-market rallies. • Back in: end of May 2009, more than a third above the March low. • Fails when the crash is fast and reverses quickly — the rule sells low and buys high.

2022: when bonds stopped hedging

2022 was a different crisis. Inflation forced the fastest rate rises in four decades, and stocks and bonds fell together: the S&P 500 returned about −18% including dividends and the Bloomberg U.S. Aggregate Bond Index about −13%, the worst year for that index in its history. For a 60/40 portfolio the usual hedge had failed. For a diversified trend-follower it was close to the opposite. The persistent moves of 2022 — yields rising, bond prices falling, the dollar strengthening, energy rallying in the first half — were exactly what trend rules ride, and many managed-futures programmes posted some of their strongest results in years. The diversification across assets did the work: being short bonds as yields climbed was as important as being out of equities. An equity-only rule had a harder year, and the replay shows why. The 2022 decline was a grind with sharp rallies in March and in the summer that crossed the 200-day average and failed. Each crossing was a small loss. The rule still beat simply holding over the months the replay covers, but less cleanly than in 2008 — a reminder that the edge lives in the diversified version, not in one index. Two bear markets, one rule — 2008: Persistent, across assets — trend rules broadly worked · 2022, diversified: Rates, dollar and energy trends — strong year for many trend programmes · 2022, equity-only: Grinding decline with failing rallies — whipsaws, smaller edge ←

The bill: whipsaws, late entries and droughts

Everything that makes trend-following work in a crisis costs something the rest of the time. The rule is wrong more often than right; it gives back profits at every turn; it buys recoveries late. Worse, there are long stretches with no persistent moves at all, and in those stretches a trend programme bleeds slowly. Through much of the 2010s — a decade of low volatility, central-bank support and quick reversals — many trend-following funds had weak returns, and many investors left them shortly before 2022 rewarded those who stayed. That pattern is the behavioural risk of the strategy, and it is as important as the statistical one. A method that pays in rare, large bursts and bleeds in between asks its owner to keep paying for insurance through years without a claim. The investor’s own exit after a drought is what turns a sound long-run strategy into a poor personal result — the behaviour gap applied to a single strategy. The practical conclusions are the ones the risk lessons already teach. Size trend exposure as a diversifier inside a portfolio, not as a bet you have to be right about this year; decide in advance how long a drought you will accept; and judge the rule over a full cycle that includes at least one crisis, not over its last eighteen months. • Whipsaws: each false break is a small loss. • Late re-entry: the first leg of every recovery is given away. • Droughts: long periods with no persistent moves (much of the 2010s). • The behavioural risk: quitting after a drought, just before the payoff. Judging a trend rule on its last year and a half is how investors buy it after a crisis and sell it before the next one.

Why trend-followers trade everything

A trend rule applied to one market is a coin that rarely lands: most of the time that market is not trending, and the rule pays for false starts. The answer the professionals found is breadth. Moskowitz, Ooi and Pedersen tested time-series momentum — buy what has risen over the past year, sell what has fallen — on 58 futures markets across equity indexes, government bonds, currencies and commodities, and found the effect in every asset class. Trends in different markets come and go at different times, so a portfolio of many weak, uncorrelated trend positions is far steadier than any single one. Breadth only works if each market carries comparable risk, which is why trend-followers size by volatility rather than by dollars (R6): a quiet bond future gets a larger position than a wild commodity, so that each contributes a similar amount of risk. The same research found the strategy did best in the most extreme months for stocks, both up and down — the pattern behind the “crisis alpha” description, because sustained declines in stocks tend to come with sustained trends in bonds, currencies and commodities that a diversified rule can ride. That is also what makes the strategy hard to hold. In calm, range-bound years every market whipsaws a little and the portfolio bleeds small losses; the payoff comes in a few large, persistent moves that cannot be predicted. Breadth shortens the waits; it does not remove them. • Time-series momentum appeared across 58 futures markets in every asset class (Moskowitz, Ooi & Pedersen). • Many weak, uncorrelated trends make a steadier portfolio than one strong market. • Size each market by volatility so each carries similar risk. • Best in extreme stock-market months, both up and down — and weakest in calm ranges. One market against many — One trend rule, one market: Rare payoffs, long whipsaw stretches · The same rule on 58 markets, volatility-sized: Many small, uncorrelated bets — far steadier ← · Where it earns most: Extreme months for stocks, up or down

Judging a trend-following record honestly

Trend-following is easy to sell after a crisis year and hard to hold in the years between, so its record has to be read with the statistics of T18 rather than the headline. Three numbers matter most. The first is its correlation with stocks in the worst stock-market months — the property it is bought for; a trend programme that falls with equities in a crash has failed at its main job, whatever its average return. The second is the depth of its own drawdowns. The third, and the one investors underestimate, is their length: trend-following indexes have gone through flat or losing stretches lasting several years. Those stretches are where most investors give up, usually just before the next large trend. That is why the practical way to hold the strategy is as a sized sleeve of a portfolio, decided in the policy (PF17) and rebalanced like any other, rather than as a bet that is added after a good year and abandoned after a bad one. A trend sleeve that is rebalanced into after a drought buys the strategy when it is cheapest; one that is chased after a crisis buys it after the payoff. The same discipline applies to judging your own rule. The 2008 and 2022 replays in this lesson show the rule earning its keep in the two years it was designed for. Ask also what the rule did in the calm years between them, and whether you would have kept running it through those years — because the crisis returns only belong to people who were still invested when the crisis arrived. • Check its correlation with stocks in the worst stock months — its main job. • Check drawdown depth, and above all drawdown length — droughts can last years. • Hold it as a sized, rebalanced sleeve, not a bet chased after a crisis. • Crisis returns belong to those still invested when the crisis arrives. Three numbers for a trend record — Correlation with stocks in crashes: Should be low or negative — the reason to own it ← · Maximum drawdown: How deep the bad years went · Longest drawdown: How long the drought lasted — where investors quit

Sources

• Trend-following over a centuryHurst, Ooi & Pedersen, “A Century of Evidence on Trend-Following Investing” (Journal of Portfolio Management, 2017)
• Time-series momentumMoskowitz, Ooi & Pedersen, “Time Series Momentum” (Journal of Financial Economics, 2012)
• Managed futures and crisis periodsKaminski, “In Search of Crisis Alpha” (CME Group, 2011)
• 2008 and 2022 calendar-year index returnsS&P Dow Jones Indices (S&P 500 total return); Bloomberg U.S. Aggregate Bond Index