Persistence of Medium-Term Trend Following
(Published by JP Bouchaud | July 2022)
The persistence of medium-term Trend Following (or “momentum”) is one of the most scathing indictments of the Efficient Market Hypothesis. Price returns over the past – say ~6 months are positively correlated with returns over the next 6 months. This means that trivially accessible public information is *not* included in current prices. Such correlations are, admittedly, quite weak, but still highly significant and persistent. Backtests over 220 years show that the trend effect has always been there, with a strength that has not substantially changed over time.
The existence of such trends stems from (at least) two separate effects.
One is underreaction: people have sticky beliefs and do not swiftly integrate new information; central banks have to act slowly not to destabilize the whole economy.
The other is…trend following itself. As traders buy the trend, the impact of their trade further reinforces it. Contrarily to the usual arbitrage argument, crowding is not making trends go away (although it might make it more costly to trade, but this is another, more subtle story.)
A disciplined, diversified implementation of trend following strategies is as good, in the long run, as buying and holding the S&P index. A little bonus is that trend following is positively skewed whereas stock indexes are negatively skewed. Of course, the performance of trend following has its low moments. But when in 2019 a number of notable names in the industry declared that trends were dead after 5 years of disappointing returns, we at CFM did not believe a word of it.
Most investors are, consciously or unconsciously, strongly influenced by past performance. FOMO is so strongly engrained in human psyche that is is hard to see how trend following behaviour could ever go away. Now, as argued above, trend following begets trends.
Since 2019, the SG CTA index (mostly trend followers) has delivered a +33% return, vindicating our belief that trends are here to stay. Such performance is totally in line with expectations based on 220 years of backtest. It is a good time for trend following, but then again, it has always been! For more on this, see this CFM report.
