Some of the best investors of all-time use trend-following models … Why you never fight the trend … Does that mean buy-and-hold is done? … A powerful tool for your portfolio
***Closed tomorrow in observance of Independence Day
Please note that our InvestorPlace offices will be closed Friday in honor of the Fourth of July weekend. We’ll re-open Monday morning. Have a wonderful Independence Day.
It’s widely regarded as one of the greatest trades of all time …
In the four years leading up to 1987, the stock market had been rallying hard.
And 1987 itself was going well … investors were making money … things seemed good …
And then, Black Monday.
On Monday, Oct. 19, 1987, stocks collapsed. The Dow Jones plunged nearly 23% in a day.
Most investors were caught horribly off-guard as worldwide losses were estimated at roughly $1.7 trillion.
But not all investors lost money …
Paul Tudor Jones had been betting on a crash. In the weeks prior to Black Monday, he had been amassing a substantial bearish position, after having been quoted earlier in the year as saying …
There will be some type of a decline, without a question, in the next 10, 20 months, and it will be earth-shaking; it will be saber-rattling.
When the market exploded, Tudor Jones profited to the tune of $100 million (about $225 million in today’s inflation-adjusted dollars).
If you look up “greatest trades of all time” there’s hardly a list that won’t contain this Black Monday payday.
Now, there are plenty of details to this story which we don’t have time to get into. But at the heart of Tudor Jones’ well-timed bet lies a market approach that most investors could benefit from understanding better — especially in today’s market …
Trend-following.
In short, a key trend-metric, which Tudor Jones watched, tipped him off that the trend in stocks had changed. Given this, he changed his orientation from bull to bear … and made a fortune.
Many investors grew up in the church of “buy and hold.” We revere Warren Buffett as our high priest, who tells us that his favorite holding period is “forever.”
Buffett is also a classic value investor. In other words, he searches for stocks that he believes to be trading at market prices that are well-below what they’re actually worth.
But are those investing styles appropriate for today’s market?
Perhaps. But they’re not the only style we should consider.
In this Digest, let’s look at why trend-following and tailored hold-periods, not value and forever hold-periods, might be beneficial for today’s market.
***An overview of trend-following
Starting with the basics, you might think of trend-following as simply “riding the wave.”
Sometimes that wave is pushing stocks higher. Other times that wave is driving stocks lower.
What you’re not doing is fighting that wave.
In other words, you’re not demanding the market bow to, say, your idea that it’s overvalued so it must fall … or perhaps your idea that a specific stock is horribly undervalued so it must rise.
With trend-following, you simply identify that trend — regardless of why it’s happening, and regardless of whether you agree with it — and hop on board until the trend changes.
So, how do you define “the trend” and how do you define when it changes?
That’s where it where it gets more complicated …
Trends appear different based on the time-parameters an investor chooses.
For instance, the intra-day price trend of, say, Apple could be opposite of Apple’s monthly trend … which could be opposite of Apple’s yearly trend … which could be opposite of Apple’s decade-long trend.
Given this, the trend timeline you use needs to be informed by your personal investment goals.
A popular trend metric is the 200-day moving average. In other words, is a stock trading above or below its average price over the last 200 days?
Above would signify strength — stay with the position. Below would signify weakness — get out.
Tudor Jones credits the 200-day moving average as the trend-following metric that helped him avoid the Black Monday crash.
But whatever trend-following parameters you choose, the approach is simple — remain invested until your system triggers “off.” When it does, get out.
Some of the wealthiest, most successful investors in history credit trend-following for their success, including George Soros, Jim Rogers, Richard Dennis, John Paulson, and Steve Cohen, among others.
***Why might the market be better suited for trend-following than a valuation-based, buy-and-hold approach looking forward?
Two reasons — valuation and an evolving marketplace.
Let’s start with valuation …
If you’re a value investor, you have slim pickings when looking at today’s market.
Using data from analytics company, FactSet, we can see that the S&P is currently trading at a nosebleed valuation according to its forward 12-month price-to-earnings ratio.
From FactSet:
The forward 12-month P/E ratio for the S&P 500 is 21.7. This P/E ratio is above the 5-year average (16.9) and above the 10-year average (15.2).
Now, sure, there are bound to be a few great value stocks out there trading below their market prices. But in general, how are you going to find a portfolio’s worth of great value stocks in light of today’s historically high valuation?
It would be a challenge.
But let’s ask the more important question …
Does today’s high valuation matter?
***The truth is valuation itself means little without trend
As any value investor would admit, just because a stock is cheap doesn’t mean it’s about to surge higher. Cheap can stay cheap for many years. Worse, a cheap stock can often confound value investors by, well, getting cheaper.
Plus, if we invested purely from a valuation perspective, then there would be long stretches — months, even years — when valuations would remain too rich for new money to be invested, yet stocks soared regardless.
Take Apple …
Over the last five years, Apple’s average P/E ratio has been 16.5. That’s about the same as the average long-term P/E ratio for the S&P 500 (nearly 16).
So, if we decided to buy Apple only when it was trading “cheap” which, let’s say, is below a P/E of 16, that would mean we wouldn’t have touched it anytime since June of 2019.
Unfortunately, this method would have cheated us out of 112% gains, as you can see below.
Valuation itself — whether high or low — means very little until the trend begins to impact that valuation.
So, why not use valuation to inform you about how closely to watch the market … yet continue with the trend as long as it’s making you money?
***Let’s turn back to “buy-and-hold” and why the market today might be less favorable to this style of investing
We love stories about buy-and-hold riches.
It’s the janitor who squirreled away $20 a month, secretly investing it in blue bloods like Coca-Cola, IBM, or Exxon. Upon the janitor’s passing, everyone is shocked to learn he’s left millions in stock to his family, or alma mater, or social group.
These are wonderful stories, but beneath them is a buy-and-hold dark side — one we’ve spotlighted here in the Digest …
Most stocks go nowhere.
About a decade ago, the team at Longboard studied the total lifetime returns for individual U.S. stocks from 1983 through 2006.
In short, the study found that the worst performing 6,000 stocks — which represented 75% of the stock-universe in the study — collectively had a total return of … 0%.
The best performing 2,000 stocks — the remaining 25% — accounted for all of the gains.
The Longboard study also found that 18.5% of stocks lost at least 75% of their value.
***Bottom line — it’s not easy to find huge, long-term winners because not many exist. And just because one existed yesterday doesn’t mean it will exist tomorrow
Take Exxon …
For decades, Exxon was the pillar of countless “mom and pop” portfolios.
From 1990 through 2010, Exxon returned 635% for its investors. Over that same period, the S&P returned just 255%.
Surely if there was a buy-and-hold poster child it would be Exxon, right?
The last decade tells a different story.
As you can see below, while the S&P has gained 200% in the last 10 years, Exxon has basically been dead-money … tacking on just 10%.
If you’re saying, “well, that’s just because big oil is down,” we could point toward former-tech all-star and buy-and-hold darling, IBM.
In the past 10 years, it’s climbed only 32%.
Looking forward, think of the rate of change we’ll experience in our world thanks to technological advancements.
While that’s exciting, it’s also dangerous …
The cutting-edge company of today that fails to keep up with tech-advancements could easily become tomorrow’s dinosaur.
Do you want buy-and-hold-dinosaurs in your portfolio?
***Trend-following in practice
When you sell a stock based on a triggered trend-following system, you’ve basically used a stop-loss.
This stop-loss is a pre-appointed level, identified by your trend-following system, that will signal “sell” because the up-trend has been broken.
As we noted earlier, Paul Tudor Jones’ stop-loss for the broad market was its 200-day moving average.
But digging deeper, what’s an appropriate stop-loss for specific stocks in your portfolio?
Well, as we highlighted in our Monday Digest, the answer will vary per the stock. And as we addressed in this Digest, it might also vary based on your personal investment goals and timelines.
But knowing when a new trend has begun — or an old trend has ended — is how some of the world’s most successful investors have made their millions.
***Last week, Matt McCall and his colleague Keith Kaplan held an event to discuss a tool called TradeStops. It’s is a proprietary stop-loss formula that’s customized to the unique fingerprint of each stock
Here’s how Keith described the tool:
What we’ve done is devise a system — based on numerous mathematical models — that helps you get out of the way of these big downturns before they happen and directly in front of the big upturns before they happen.
The bottom-line benefit is you position yourself to ride positive trends longer, while avoiding the losses that often follow broken trends.
It’s basically using mathematical rules, not emotions, to achieve better investment results.
To learn more about TradeStops, click here.
As we wrap up, if you’re a frustrated buy-and-hold value investor, I’d encourage you to examine a trend-following approach today.
After all, at the end of the day, would you rather have the greatest value-stock in the world that goes nowhere? Or the most horribly-overvalued — yet uptrending — stock in the world that makes you 100%?
Have a good evening,
Jeff Remsburg
