Results, as of March 31, 2023

Making money in bear markets.

Our strategies delivered positive returns during the 1st quarter and, while we are happy to make money during bear markets, we’ll continue to invest cautiously and always with a focus on risk management and downside protection.

The bear market that started in 2022 has not ended, even though the first quarter of 2023 saw market strength and a second consecutive quarter of gains in the S&P 500.

• The S&P 500 rose 7% during first quarter, after finishing last year down 19.44%.
• The Nasdaq rose nearly 17% during the first quarter but is still 24% below all-time highs.
• The Dow rose only 0.38% during Q1 and the US bond index rose almost 3%.
• A traditional allocation of 60% stocks and 40% bonds was up approximately 5.5%.

The Fed increased interest rates two times by 25bps each during the first quarter, in its continued attempt to attack inflation. The likelihood of a soft landing in the economy wanes as inflation stays persistently high and more rate increases are needed to achieve the Fed’s long-term inflation goal of 2%. The next report of CPI will be released on April 12th (March data) and the Fed’s next FOMC meeting concludes on May 3rd.

A recession is a big risk to the stock market recovery as corporate earnings estimates would be revised lower on expected declines in revenue and profit margins. This could be the driver for another leg down in the stock market and could lead to the bottom of this bear market.

Regardless of whether a hard or soft landing occurs, our strategies can adjust to market conditions to take the guesswork out of investing. If the market continues to meander higher, we’ll participate as much as possible while adhering to our risk management rules. If the market sells off in anticipation of a recession, our predefined exit points will move us defensive to protect client capital.

Models

TREND PLUS

The Trend Plus strategy was up 3.3% during the quarter and, after losing much less than the broad market and traditional 60/40 allocations during 2022, does not require as large of a return to fully recover and begin making new investment gains for clients.

The strategy participated in a positive uptrend in January and also at the end of March. The graph below shows the times at which Trend Plus was invested in the market (green) versus positioned defensively (red). The strategy remains invested in the uptrend that started late March.

SECTOR ROTATION

The Sector Rotation momentum strategy was up 1% during first quarter, on the heels of being up 1.4% during the fourth quarter of 2022.

The strategy began the year in defensive positions but re-allocated to equity ETFs when our Macro Monitor sell signal turned off in February. Sector Rotation moved partially into aerospace & defense, industrials, and materials at that time, while maintaining some exposure to defensive positions of gold, US dollar, and short-term US treasuries. The materials position stopped out in mid-March and industrials delivered a loss in the quarter, but positive overall results were driven by gains in aerospace & defense and gold.

The strategy is now fully allocated in equity positions for the 2nd quarter in communications, technology, and consumer discretionary, with individual stop levels being monitored daily in case of weakness in any one of these sectors or if there is deterioration in the broad market.

TPSR (50% Trend Plus & 50% Sector Rotation)

The TPSR strategy was up 2.1% during the quarter with positive results in both component strategies. This blended strategy has the ability to be reactive to changing market conditions and will participate nicely if the market rebound continues, while still focusing on moves defensive to protect client capital if the bear market worsens.

Summary

It is great when we are able to achieve positive returns for a quarter in the midst of a bear market, but what is more important for our investors will be the downside protection that our tactical approach offers if the bear market gets worse. 

We feel strongly that all investors should have an allocation to tactical strategies such as ours to improve their overall portfolio performance and make it through bear markets more successfully. Please contact us if you have any questions about our strategies or how MSCM can play an important part in your investment management plan.

Our strategy sheets are accessible through the buttons below, and on our website mscm.net.

McElhenny Sheffield Capital Management, 4701 W. Lovers Lane, Dallas, Texas 75209, 214.922.9200

4Q22 Results, as of December 31, 2022

2022 has ended, but the bear market – and need for risk management – remains!

2022 ended with the stock market delivering its largest yearly losses since 2008. The 4th quarter of 2022 saw new bear market lows in the S&P 500, Nasdaq, and Bloomberg Agg Bond Index.

• The S&P 500 finished the year down 19.44%, after being down nearly 25% at its lowest point in the year on October 12th.
• The Nasdaq finished the year down 33.1% with its lowest point being down almost 35% on December 28th.
• The Dow dropped in December to finish the year down 8.78%.
• The Bond index finished down 13% for its worst calendar year performance in many decades.
• A traditional allocation of 60% stocks and 40% bonds was down approximately 17%.

The main theme driving markets in 2022 was inflation; it’s causes, how long it would persist, and how the Fed would respond to it. The Fed moved in historic fashion to raise interest rates, making seven consecutive rate increases totaling 425bps, but inflation is still too high, and the Fed has stated more rate increases are needed and that rates would be held higher for longer to get inflation to their desired goal of 2%. The rapid monetary tightening aimed at bringing down inflation will ultimately succeed, but the cost will likely be a global recession in 2023. The story for 2023 will continue with inflation as the main theme but will soon be dominated with talk of a recession.

The drop in the stock market during 2022 improved equity valuations some, but the market is still overvalued by most estimates. The growing likelihood of a recession is a big risk to corporate earnings, as a recession would mean revenues decline, and profit margins compress from their current cyclical-high levels. Another leg down in the stock market (and possibly the bottom of the bear market) may come as companies reevaluate their earnings expectations to account for a global recession.

Given the high likelihood of a recession, active investors may feel sitting in cash is their best option right now, but without a disciplined approach for re-allocating capital when the investing environment improves, most investors will inevitably stay in cash far too long and miss out on the growth potential that comes after bear markets. We think the better approach is to invest using the MSCM risk-managed strategies, which can participate in market upside when appropriate, while always maintaining downside protection if this bear market worsens.

Models

TREND PLUS

The Trend Plus strategy was down 9.9% in 2022, ahead of the S&P500, Nasdaq Composite, traditional 60/40 allocations, and even down less than the U.S. bond benchmark for the year. After the early January 2022 move defensive, the strategy attempted to participate in several of the counter-trend rallies that occurred during the year, but each bear market rally eventually failed and Trend Plus was stopped out to avoid riding the market to lower levels. Risk management and downside protection are critical to generating long-term performance and we know we can come out ahead by minimizing drawdowns in the bad markets. The graph below shows the times at which Trend Plus was invested in the market (green) versus positioned defensively (red). Even though the model suffered a few whipsaw trades, the ability to avoid the large down moves in the market kept us ahead.

SECTOR ROTATION

The Sector Rotation momentum strategy was down 13.7% in 2022, well ahead of the S&P500, Nasdaq Composite, and traditional 60/40 allocations. Sector Rotation also only had a drawdown during the year of 15.5% (peak-to-trough move), while at one point the S&P 500 had lost a full quarter of its value (down 25% in October). Drawdowns are painful to investors and reducing the magnitude and duration of drawdown periods ultimately provides a smoother ride for our clients. The strategy did not suffer any whipsaw trades since moving defensive in February. The defensive positions have had mixed performance with U.S. Dollar showing strength while gold lost ground for most of the year, while during the 4th quarter gold established itself in an uptrend and was additive to the strategy returns.

The strategy remains defensive with no equity exposure and will protect client accounts if a further selloff is experienced in the stock market.

TPSR (50% Trend Plus & 50% Sector Rotation)

The TPSR strategy was down 11.7% in 2022, well ahead of the broad market that was down more than 19% and traditional 60/40 portfolios that were down 17%. Having exposure to both Trend Plus and Sector Rotation strategies has provided good results during a tough market environment, ultimately beating benchmark returns through superior risk management. This blended strategy has the ability to be reactive to changing market conditions and allocate quickly if a market rebound occurs, while still focusing on moves defensive to protect client capital if the bear market worsens.

Summary

We have stated many times in our investor updates that nobody can know if the bear market is over until the market attains new all-time highs. Allocating investors’ capital based on guesses that the “bottom is in” is foolish and a recipe for disaster, although many take this approach. Our approach is very different and, we think, a much better way to invest client assets. Our disciplined, rules-based, quantitative approach to investing is robust, has been time-tested, and has delivered outstanding results across many market environments – including protecting investors from significant drawdowns this past year.

We will attempt to participate in market rallies when they occur, but always with a focus on risk management and downside protection. Compounded returns over time are greater if smaller losses are taken during bear markets and that is what our strategies delivered in 2022.

We feel strongly that all investors should have an allocation to tactical strategies such as ours to improve their overall portfolio performance and make it through bear markets more successfully. Please contact us if you have any questions about our strategies or how MSCM can play an important part in your investment management plan.

Our strategy sheets are accessible through the buttons below, and on our website mscm.net.

McElhenny Sheffield Capital Management, 4701 W. Lovers Lane, Dallas, Texas 75209, 214.922.9200

Investors may have the blues right now because we find ourselves in another bear market just 17 months after recovering from the prior one. The last bear market started on 2/19/2020 and ended on 8/18/2020 and was the 6th worst bear market since 1927 (of the S&P 500 Index and predecessor indices), dropping over 33.9% at its lowest point. It was however the quickest bear market by far, taking less than 6 months from when the selling started before the S&P 500 attained a new all-time high.

Below is our updated bear markets table showing the prior 11 bear markets ranked by the magnitude of their decline from largest to smallest. The bear market that we currently find ourselves in is tracked in the bottom row “CURRENT” and shows that we’ve dropped over 23.5% so far over the last 5.4 months; January 3rd being the prior peak in the S&P500. 

We’ve mentioned in previous articles (Trend and Trend Plus – Drawdown | Dancing with the Trend) and will reiterate here – the magnitude of the drop during bear markets isn’t the only factor that destroys the wealth of investors – it is also the duration of the bear market; the length of time it takes the market to fully recover from being in a bear market. If you are in a mild bear market that lasts a few years and must make monthly withdrawals from your account to pay for retirement living expenses, the long duration of the bear market can do more to destroy your wealth than would a higher magnitude bear market that recovers much more quickly. The amount of withdrawals made during the bear market greatly exacerbates the impact to your portfolio; this impact was also discussed in a prior article (Old Bear, New Trick | Dancing with the Trend).

If we exclude the crash of 1929 for being an extreme outlier in the data, the average bear market drops 35.6% (magnitude) and lasts 39.4 months (duration) – that’s more than 3 years and 3 months! The bear market of 2020 had close to average magnitude but its duration was so short you could blink and miss it. If you didn’t keep up with the financial news during that time and only reviewed quarterly account statements, you had only one quarter where things looked bad (1Q20), by the next quarter you were down less than 10% (2Q20), and during the third quarter you went back to all-time highs (3Q20). That is not a normal bear market by any stretch and investors should not look at that as an example of what we’re going through today.

The current bear market already has duration about as long as the one from 2020 and it looks as though we are still heading down. Nobody knows where the bottom will be and how long it will take to get there, and nobody knows how long it will take to recover from the low point either! If someone tells you that they “know” how this bear market will play out, you should ask for their verified track record on all their other market guesses – they likely have made hundreds of market calls in an effort to be correct on just a few! Not the type of person that should be trusted with investments. We would also not make a bet with investment capital that the Fed can orchestrate a soft landing for the economy, i.e., bringing inflation into normal ranges without stifling the economy. Their track-record on this is abysmal.

Since we feel strongly that nobody can reliably predict when bear markets will occur, how far down they’ll go, how long they’ll last, or what will cause the next one (or much of anything else regarding financial markets), we use rules-based trend following to avoid the constant need to make guesses about the future. We don’t have to guess and hope to be correct about the market, economy, Fed policy, inflation, corporate earnings, government policy, or anything else. We agree that these things likely matter to stock market performance, but not that you can “solve” the riddle of the markets based on these forecasts to make sound investment decisions. Additionally, the behavioral aspects of investing and that humans are notoriously poor decision makers when faced with uncertainty also supports the folly of trying to invest based on forecasts, predictions, or guesses about the future.

Instead, we follow rules that react to what the market is actually doing – that’s it. If the market is moving up, we try to participate, but when we detect breaks in the uptrend and the market moves through our stop level, we sell out of equity positions and stay defensive to protect clients’ capital. The mere existence of bear markets (not what causes them or how bad they will be) is one of the reasons we prefer rules-based trend following to other forms of money management. The fact that bear markets exist and that trend following does a good job of avoiding them, along with our expectation that bear markets will continue to occur in the future, is what makes trend following a very useful approach to managing serious money. Over full market cycles we’ve found trend following can deliver significant returns while suffering much lower volatility and drawdowns than the broad market, ultimately compounding capital at a higher rate for investors – that should be “good news” for trend followers.

Buy and hold approaches to investing (either active or passive forms) that maintain fairly constant equity exposure during bear markets don’t employ any real risk management techniques. The only way one attempts to lower the risk of these strategic asset allocation portfolios is by mixing in larger allocations to bonds to hopefully de-risk the equity allocation. Sometimes this works and sometimes it doesn’t, ultimately the bond exposure is usually a drag on returns while providing very limited downside protection. In 2022 the bond allocation in most strategic asset allocation portfolios is suffering almost as much as the equity portion. In a rising rate environment this is likely to continue.

Instead of using bonds to de-risk, our trend following approach is fully tactical in that it can move from being 100% invested in the stock market to being 100% defensive with no exposure to the stock market; and our defensive holdings can vary from cash to gold to short and intermediate Treasuries – assets that often perform very well during equity bear markets and market environments that see panic selling. We believe that this form of risk management, being tactical and using stops to get out of the way of bear markets, is much better for investors as large drawdowns are far too difficult for most investors to tolerate. Investors always think they can hold their positions thorough any level of downturn and make it out the other side. Bear markets prove time and time again that investors abandon their investment plans at various levels of drawdown and then have no plan on how to re-allocate once the bear market is over. Remember, buy & hold only works if you can accomplish the “hold” part.

Below is the 2022 view of the Nasdaq Composite chart we’ve shown often that illustrates the times that our trend model has us invested (green) and the times that it has us defensive (red). Previous articles show the same chart for 2021, 2020, and older periods. You can see from this chart that our model got us defensive very early in the year, and other than a quick trade at the end of March, has been defensive all year – avoiding the devastation to wealth that comes with bear markets.

The defensive positions have had mixed results so far this year. Below are the year-to-date returns (net of fees) of the main strategies that follow this model so far in 2022 (as of June 17th) compared to some benchmark returns:

Avoiding the market this year with the move into defensive positions has clearly provided a significant amount of outperformance for investors.

Making the same comparison since 2020 when we had the last bear market, and even though 2020 and 2021 provided strong returns in the benchmarks, the power of not losing in the bad times keeps trend following ahead, and all along investors experienced much lower levels of drawdown during the two bear markets:

Admittedly, 2021 results were not great on their own and the large underperformance to the market was difficult to tolerate for many investors; however, we are not investing with a focus on any single year or specific timeframe. Many investors get impatient with the results during the ho-hum years like 2021 when trend following is underperforming the market. We’ve discussed this in many prior articles. Losing sight of the long-term results that trend following can provide, and of their long-term goals for investing, causes investors to chase performance and abandon trend following to move into the group of funds or strategies that just had the best recent performance – selling what they owned and don’t like anymore to buy what they wish they had owned – in essence, selling low and buying high. Last I checked that was a fairly poor investment plan, and sadly professional advisors are guilty of doing this for their client portfolios, too.

We think it is better to understand what market environments will cause underperformance in trend following and accept that “bad” as a tradeoff for the “good” that it provides at other times, i.e., don’t give up on trend following in times of underperformance to assure you receive the benefit it provides in times of outperformance, namely during painful bear markets when other strategies and investment approaches are doing so poorly.

If this current bear market is giving you the investing blues and you have struggled to develop your own trend following or tactical investing approach, you may be interested in the rules-based tactical strategies offered by McElhenny Sheffield Capital Management (mscm.net/strategies/), or the ETF that is based on MSCM’s primary tactical strategies, Trend Plus and Sector Rotation, MSMR (mscmfunds.com). You can reach out to Grant directly by email (grant@mscm.net) for more information.

We strongly believe that all clients should have an allocation to trend following and other tactical strategies for the good news they deliver to investors during bear markets.

Dance with the Trend,

Grant Morris

Grant manages various tactical strategies at MSCM for individual investors and other registered investment advisors. The content of this article is for general informational purposes only. Nothing contained should be construed as an offer to sell or a solicitation to buy any security or other financial instrument or product offered or managed by MSCM or any other issuer or company. The provision of this information does not constitute the rendering of investment, consulting, legal, accounting, tax, or other advice or services. Past performance is no guarantee of future results.

We think it is a good time to revisit a topic that is always top of mind for tactical money managers and investors in rules-based strategies like trend following; and that is whipsaws.

Whipsaw trades are the one issue that will constantly concern investors using trend following strategies. Whipsaw trades can cause losses or cause you to miss out on gains, and aside from those monetary impacts, they are difficult to tolerate emotionally. If you are going to do anything different than being a buy & hold investor, you are always going to compare to “what could have been” if you were using a buy & hold strategy.

A whipsaw is basically a trade or change in your investment position that the market does not cooperate with. There are two ways to get whipsawed when trend following. One is to move from being invested to being defensive (i.e., selling) and then the market moves higher and forces you to buy back in at a higher price.

This type of whipsaw does not necessarily cause losses in your account but does cause you to miss out on gains. This trade makes investors think that if they stayed invested and not sold when they did, their account value would have increased; “Everyone else is getting rich and I’m not!”

The second type of whipsaw is when you are defensive and move to being invested (i.e., buying) and the market moves down after you enter, forcing you to sell at a lower price.

This type of whipsaw does cause losses in the account and makes you think that if you weren’t so anxious to buy, you could have bought in later at a lower price; “I’m buying high and selling low, this strategy is not working!”

Whipsaws are an inevitable consequence of eschewing the buy and hold approach that will eventually cause you to become a victim of a bear market. Whipsaws are the “cost of doing business” if you want to avoid the devastation that comes during bear markets. We know this fact to be true, watching the market plummet from the sidelines is not a bad thing, emotionally or financially. We never know if a few down days are going to turn into a correction, or if a correction is going to turn into a bear market. No one can reliably predict such things (even though countless people try), but at least we are always prepared for the worst outcome. That is why we accept whipsaw trades in our trend following approach – for the benefit of the downside protection our selling rules provide. It allows us to try to participate in the good times and avoid the bad times. Are the calls always correct? Are the trades always positive? Definitely not, but we know that there is only one thing worse than being wrong, and that is staying wrong.

We don’t think there is any way to get over whipsaw trades. We hate them, our clients hate them, and people quit using investing strategies because of them. Yet, they are never going away, they are absolutely part of the process and cannot be avoided. We think it just takes experience to get used to whipsaws, if one ever does. Taking a longer-term view of a strategy’s investment results and not focusing on the current trade that may not be working is one way to make whipsaws more tolerable.

There are, however, ways to reduce the number of whipsaw trades that occur in any rules-based strategy, and that is to de-sensitize the model to the market’s actions; one such example would be using wider stops. We caution against this approach to whipsaws as it may reduce the frequency of them, but can also reduce overall performance, especially during bear markets. Having wider stops means you’ll stay invested during more uptrends, as smaller pullbacks do not trigger selling, but you’ll inevitably not get out of the way as quickly during corrections and bear markets, forcing you to ride the market down further before selling. Know that whatever stop level you choose, there will be times when the market does not cooperate. Adjusting a model based upon sound principles so that the whipsaws in the recent past are reduced or eliminated likely leads to whipsaws at other times and worse returns where it matters most – in the future.

Ironically, most buy & hold investors are really just very de-sensitized tactical investors, because they do eventually sell near market lows when the pain of further losses is far more than they can tolerate! Very few have the ability to always implement the “hold” portion of buy & hold, and we don’t think it is a good plan for most investors with serious money at stake. We think it is better to accept the whipsaws and avoid the devastation of bear markets.

Dance with the Trend,

Grant Morris

Trend Plus

Our Trend Plus strategy delivered a net return after fees of 1.6% during 2021, while a 60/40 portfolio was up about 14% and the S&P 500 was up 26.9%. Underperforming the broad market or benchmark portfolios can be very frustrating to investors, but as we’ve said many times in this blog, it is better to deal with frustration then devastation. Devastation comes from watching your capital evaporate during a bear market, panic selling after the damage has been done, and then not being able to participate in the eventual recovery out of fear that more losses could occur. The Buy & Hold approach is truly devastating at times to investor’s confidence and their retirement plans.

The frustration of our chosen investment approach can somewhat be mitigated by examining the goals of the strategy and whether those goals continue to be met. We are never focused on outperforming the broad market or other benchmarks in a specific time period like months, quarters, or calendar years. The primary goal (#1) of our strategy is to deliver good returns over time, especially over full market cycles, while avoiding the large losses that are seen in bear markets.

Our other goals are to (#2) deliver higher risk-adjusted returns than the S&P or reasonable benchmarks and to (#3) beat the S&P500 over full market cycles. A full market cycle includes a bull market and a bear market. You have to include a bear market in the comparison to the S&P or it is not a reasonable comparison, since most tactical strategies like ours deliver a significant amount of outperformance when they avoid the damage of bear markets. That cannot be overlooked. Of course, if you think we won’t have any more bear markets in the U.S. you might as well stop reading now, and good luck to you!

Related to goal #1 is that we want to invest in a way that never causes a client to panic sell for suffering large losses. Advisors that use the Buy & Hold approach to investing will put their clients in that situation multiple times throughout their careers. We avoid that scenario by focusing on risk management and downside protection.

Below is a chart of the Nasdaq Composite index for the year, shaded green when Trend Plus was invested and red when Trend Plus was defensive. The Nasdaq was up 21.4% during the year. The blue lines break the year into quarters and the net return of Trend Plus is shown for each period. From this chart you can see our model getting invested after an uptrend begins, only to be stopped out (sometimes quickly) when the market pulled back. Losing money in defensive positions during Q1 and multiple whipsaw trades in Q3 attributed to most of the underperformance.

Many will look at the year-end number of the major index returns and conclude that the market moved straight up all year. This was definitely not the case. The Nasdaq had several pullbacks between 6-8% and was in a full correction, down more than 10%, in March (shown below). 

Trend following works best when the market trends, and during 2021 the market never had a sustained uptrend (or downtrend, for that matter). Thankfully, we know from our research that the U.S. equity markets do exhibit many periods of trend and our belief is that our strategy will be able to capitalize on those periods, all while avoiding major drawdowns.

Looking beyond just the one year allows us to see if we are still achieving our goals in terms of returns. Over the three-year period, Trend Plus has had average annual returns of 18.7%, versus the 60/40 portfolio of 17.3%, and over the five-year period of 14% versus the 60/40 portfolio of 12.2%. Keep in mind that the three-year and five-year periods take into account the underperformance of 2021. The 60/40 is a more appropriate benchmark based on the risk of our strategy.

Trend Plus Metrics:

Sometimes a single strategy is hard to stick with even if it is meeting the stated goals, because it is hard for investors to not compare it to the S&P and they often get frustrated if the relative performance to the S&P lags by a lot. Investors often chase returns and may go elsewhere when they see a strategy underperform. No strategy or investing approach can beat the S&P500 over every timeframe…that seems to be what people expect, but it doesn’t exist. That is why at MSCM, we typically incorporate at least two distinct tactical investment strategies in client accounts to help offset the periods where any given strategy may underperform. This is just another form of diversification – diversifying by strategy type as opposed to just by asset class and geography.

Sector Rotation

The second main tactical strategy that we run is called Sector Rotation and it is a momentum strategy that invests in the top three ETFs from our investment universe, based on our proprietary momentum ranking criteria. Our universe of ETFs covers the main S&P sectors, plus some ETFs to provide sub-sector/industry exposure in market segments that may behave differently than their sectors, and a few broad market ETFs. The strategy allocates 40% to the top ranked ETF and 30% each to the second and third ranked ETFs. Positions always have stop loss protection and we use a longer timeframe signal to move the whole strategy defensive when the chance of a bear market is high.

The strategy is 100% rules-based and fully tactical, meaning that we don’t continue to use momentum to score ETFs when it looks like the market is in a downtrend. Using momentum when the stock market is going down just means you are buying what is going down the least…likely the more defensive sectors (utilities, consumer staples, etc.). We don’t want to own what is going down and would rather move to defensive non-equity positions (gold, treasuries, U.S. dollar) that have a chance of appreciating during a market selloff.

Sector Rotation was built independently of Trend Plus; it is trying to take advantage of a different market factor and uses entirely different indicators and rules. The strategy has positive expected returns and delivers very similar risk and return metrics as Trend Plus.

Sector Rotation Metrics:

The good thing about having both of these models available to run in a single account is they have a low correlation to each other, so investors receive a huge diversification benefit by allocating to both. When one strategy is underperforming the other strategy is usually doing just fine, and vice versa. We think the combination of both strategies can handle just about any market environment and work to deliver a smoother investment path for clients.

TPSR

In fact, we have a strategy called TPSR that is a 50% allocation to Trend Plus and a 50% allocation to Sector Rotation. The TPSR approach delivers an even better risk adjusted return than either strategy on its own (this is the diversification benefit). The TPSR strategy also has a low correlation to traditional/non-tactical portfolios such as those built with strategic asset allocations. During bear markets, TPSR often has a negative correlation to those traditional portfolios, providing true uncorrelated returns and diversification to the investors.

TPSR Metrics:

We even recently launched an ETF based on this blended strategy. One of the biggest benefits of having the strategy in an ETF wrapper is that investors can buy the ETF and own it long term and it should be more tax efficient than allocating to the strategies in separately managed accounts, since the ETF can avoid passing through most capital gains. An investor owning the ETF might only realize gains when they sell a share of the ETF. If they own the ETF for more than 12 months, those gains are likely taxed at the more favorable rate as long-term capital gains. An investor not needing liquidity might defer most taxable gains indefinitely. We think the ETF will be a great way for investors and advisors with traditional portfolios to add additional diversification into tactical strategies and improve their investment outcomes.

If you want to learn more about our tactical strategies or the new ETF, please go to www.mscm.net.

Dance with the Trend,

Grant Morris

Investing successfully for the long term requires a balance between give and take, choosing the pros and the cons of different investment approaches, taking the good with the bad, and accepting the risks with the rewards of investing. In other words, you can’t have it both ways. You can’t have your cake and eat it too; you will have to make some tradeoffs between what you want and what you need. Some investors expect to have all of the good without any of the bad, to get the rewards but not take the risks, to participate in all the upside and avoid all the downside. That is not possible and never will be. Chasing investments or investment strategies that promise the reward without the risk is foolish and will always lead to disappointment. It is much better for you to make an honest assessment of what tradeoffs you can tolerate and invest accordingly.

If you are the type of investor that likes to have your investment accounts at all-time highs whenever the market is making all-time highs, you should probably just be a passive index fund investor. You can do this with low-to-no-cost ETFs that give you exposure to the same market indices discussed on the financial news networks every day. When the news proclaims the market is at all-time highs, if all of your money is in an S&P 500 index ETF, then you will feel great that your account is also at all-time highs. Of course, when the S&P 500 is in a bear market, your account will be too.

It is important to realize, though, that choosing to be a passive investor tied to a particular index doesn’t free you from having to make tradeoffs with your investments – you are still accepting the good and bad of passive investing and making a tradeoff with all the other ways one could invest. The “good” is the long-term returns of the index, the strong bull market periods, never underperforming the market, and having your account at all-time highs when CNBC is lauding the market highs. The “bad” is that you will never beat the market, you’ll have high volatility, you’ll have periods of sheer terror when massive drawdowns occur during bear markets, and there will be long periods of time spent just recovering losses after a bear market has bottomed with a drawdown of 30%, 40%, or 50%.

If you want the “good” listed above, you have to be willing to accept the “bad” too. You can’t have one without the other.

People often choose to invest differently from a passive, index-based portfolio, in hopes of having their allocation change drive some outperformance to the market. It takes effort to do things differently, so unless there is an expected benefit, why else would one attempt it? The reasons could be numerous, but at the end of the day, if you do anything different than passive index investing, you are implicitly (or explicitly, for some) making tradeoffs in these good and bad aspects to investing. You are changing what risks you are willing to accept for the returns you seek.

If you are an investor with a typical benchmark 60% stock (SPY) and 40% bond (AGG) allocation, you have many portfolio-construction levers to pull (i.e., tradeoffs to make) in your effort to “beat the market”. You may stay passive and chose to incorporate allocations to other index ETFs, such as the Nasdaq Composite or to the Russell 2000, because you think they’ll outperform the large-cap stocks of the S&P 500. That outperformance could come from larger upside returns or smaller downside returns. Some tradeoffs you just made are that you may not be at all-time highs at the same time as the S&P 500 but you may have lower volatility because your portfolio is more diversified. You could also change your bond allocation away from AGG by incorporating longer- or shorter-duration bonds, or higher or lower credit quality, etc. These are all tradeoffs you are making with the “free and easy” benchmark portfolio, and you should be aware of them and why you are willing to make them.

Maybe instead of passive investing you move to a more active strategy that involves stock picking, like trying to invest in a subset of S&P 500 stocks that will outperform the index. Stocks could be selected based on fundamental analysis, technical setups, or factor-based screening. You are still trading benchmark performance, with its specific risk and reward profile, for a different investment approach that may or may not have better returns or risks. One should assess if the new risk and reward profile is desirable and justifies the difference from the benchmark. One also should understand the tradeoffs made and if they are acceptable – i.e., if the difference from the benchmark is tolerable by the investor.

We think it is very important to have a good understanding of why you may want to be invested differently and the tradeoffs that are being made with the different allocation. Knowing and understanding how and why your portfolio will behave differently than the benchmarks is key to having the discipline often required to stick with something that is different.

We choose to invest differently because we know that the “bad” that comes with passive investing is just not acceptable to the vast majority of investors. We primarily manage strategies that are rules-based and 100% tactical. This means that we can move from being 100% invested in the stock market to being 0% invested in the stock market (100% defensive) based on the rules of our tactical ETF strategies. Why do we choose to manage money this way? For two main reasons: (1) the math of compounded returns, and (2) we believe it is what clients NEED, whether they recognize it or not.

#1, The Math of Compounded Returns

Let’s use a real-world example to illustrate. The US stock market had its first bear market in more than 11 years during 2020, due to the global pandemic. Here are the monthly returns of the S&P 500 since 2020, and the average and cumulative compounded returns during these years.

The S&P 500 has an average return each month of 1.54%, while the cumulative compounded return over this time period is 33.33%.

As mentioned in previous articles, our Trend Plus strategy did very well at getting out of the way of the COVID bear market and avoided all of the drawdown that occurred during the first half of 2020. Below are the results of Trend Plus over the same time period.

Trend Plus has an average return each month of 1.50%, while the cumulative compounded return over this time period is 34.45%.

Trend Plus had a smaller average monthly return than the S&P 500 but the compounded return on Trend Plus is greater – and compounded returns are what matter to investors. This result is what we mean by the “math of compounded returns.” If you can avoid large negative months (or quarters, or years), your returns can compound at a higher rate over time since large negative numbers destroy compounding – it’s just math. Same as the trend-following truism that says, if you are able to miss most of the bad times, you don’t have to participate as much on the upside to still come out ahead. 

#2, What Clients Need

For reason #2, we have found that most clients cannot tolerate large drawdowns. They NEED an investment approach that focuses on risk management rather then what they say they WANT, which is typically to achieve outsized returns. Most investors cannot successfully ride the bear market down 33.9% (like we saw the S&P 500 drop in 2020) and continue to hold onto their position until the market fully recovers. In theory, this type of investor must exist (academic finance is entirely based on their existence), but in practice, we never find them. The losses in bear markets are far too great to withstand. This is especially true for investors that are nearing retirement or already retired. Bear market losses can completely devastate your retirement plans when time isn’t on your side to wait for a recovery. Thus, clients NEED risk management and a way to avoid the devastation of bear markets, while still getting “good” returns during bull markets.

Over the same months shown in the tables above, when the S&P 500 suffered the 33.9% drawdown, the Trend Plus maximum drawdown was only 10.7%. This happened in October 2020 just after the S&P 500 had fully recovered from the bear market (notably, our drawdowns occur at different times than the market’s). We firmly believe that drawdown is the best measure of risk (as discussed in previous articles), and so our Trend Plus strategy was able to deliver higher compounded returns over this time period while taking significantly lower risk – that is why we invest differently.

There is no such thing as an investment strategy that gets it right all the time or has all the good without any bad. People always look for the holy grail of investing, something that provides the upside returns of the S&P 500 and somehow avoids the downside. It doesn’t exist. What can exist is an acceptance of which risks and “bad” results you can tolerate, then find the strategy that provides the best returns based on accepting those risks.

The tradeoffs we make to manage money through our tactical strategies are numerous, and we have to fully accept the “bad” aspects of our approach. We suffer whipsaw trades and often underperform the benchmark portfolios, we frequently are not at new highs in our strategy when the market is making all-time highs, we have down days and months when the market is up, etc., etc. We are willing to make all of these tradeoffs in order to achieve the results that we and our clients NEED, even if it’s not always what we WANT.

For tactical strategies, like the ones we manage at McElhenny Sheffield Capital Management (mscm.net/strategies/), we think it is better to understand what market environments will cause underperformance and accept that “bad” as a tradeoff for the “good” that we provide at other times. Namely, when the major corrections and bear markets come, we typically do very well and tend to come out ahead.

If you are interested in using our trend following or other tactical strategies, you can reach out to Grant directly by email (grant@mscm.net). Grant manages various tactical strategies at MSCM for individual investors and other registered investment advisors.

Dance with the Trend,

Grant Morris

Trend following can offer benefits as an investing approach even when not generating positive returns. Sometimes the benefit comes from not losing, or not losing as much as other investment approaches; other times the benefit comes from allowing you to sleep more soundly at night, as selling out of equity positions before the stock market goes into a correction or a bear market is much more comfortable and will reduce an investor’s stress and anxiety.

While being defensive during market selloffs can be comfortable, a frustrating part of trend following is that you often have many small loss trades or miss out on some potential upside while being defensive. This must be tolerated to realize the long-term benefits of the approach. Investors who focus on every trade and very short-term results tend to not be good at trend following – they’re usually the same investors that are not good at sticking with other approaches either. There is no such thing as a strategy that is going to be positive every day or in every trade. There is also no way to reliably “call” market tops and bottoms – many try to guess that certain days are a top or bottom, and sometimes are shown to be correct in hindsight, but they’re really just guessing.

The last few months have been one of the frustrating periods in our trend following strategies, which focus specifically on the Nasdaq market (some of our reasons for focusing on the Nasdaq have been discussed in previous articles, like: Building a Rules-Based Trend Following Model – 6 | Dancing with the Trend | StockCharts.com). The Nasdaq Composite had a strong uptrend from early November to mid-February then rolled over and went into a correction in March, as investors were rotating out of tech and growth stocks and into value stocks. Investors watching only the S&P 500 Index or Dow Jones Industrials Average might not have noticed the correction since those indices were never down more than 5% while the Nasdaq Composite was down 10.54% on March 8th (and has yet to fully recover, although the closing value on 4/16 was close).

The purpose of our trend following approach is to participate in as much market upside as we can, but to avoid the devastation of large losses. Below is a graph of how our model handled this time period. 

We participated in the uptrend from mid-November to mid-February and got stopped out of equity positions in late February as the Nasdaq was selling off. We were defensive (and sleeping comfortably at night) as the Nasdaq continued to sell off into correction territory in March. The Nasdaq began trending up on March 10th, but it took until April 5th for our model to indicate a buy signal, whereby we got back invested in equities just above the level at which we went defensive in February. While selling out of the equity ETFs to protect capital prior to the Nasdaq moving into a correction was beneficial to our sleep and our investor psyche, it ultimately did not boost returns. The defensive positions that we use in Trend Plus did not go up while we owned them since we never saw panic selling in equities or the flight-to-safety trade that usually causes those defensive positions to pay off. We also bought back into the equity ETFs at a higher level then we sold, so now, and ONLY with the benefit of hindsight, can we say we would have been better off not selling at all.

Why then do we move defensive during times when it often doesn’t increase our returns? A bit too obvious to state but we’ll do it anyway, every bear market starts first as a correction, and every correction starts first as a 5% pullback. If you want to run a tactical rules-based strategy, you must decide what size decline you are willing to withstand in an effort to deliver the results you want. This is a balancing act between selling early to avoid further losses and not selling too soon to allow participation in potential upside. The tighter your stops, the more whipsaw trades you will have but you’ll also be getting out sooner when the 5% drawdown does turn into a 10% correction or a 20% or more bear market. Wider stops keep you invested longer with fewer whipsaw trades, but you move to protect your capital more slowly when the big pullbacks come. Deciding what stop level is best for you to use is as much about testing what worked in the markets historically as it is about making a behavioral assessment on what you (or clients) can tolerate. Our Trend strategies have stop levels that fluctuate between 1.25% and 6% and are dependent on our model readings of the strength of the uptrend.

Be careful about trying to calculate an “optimal” stop level based only on how it performed historically. This can be problematic because as soon as you start using it in live trading, it likely won’t perform as optimally as your backtest and after a few painful whipsaw trades, you may decide a new “optimal” stop level is needed. Constantly tweaking your rules based on recent trades is the same as not having rules to begin with.

While sometimes our trend following approach can be frustrating, we’ll take frustration over devastation every day of the week. Devastation is what you experience in a bear market. Riding the market down 20%, 30%, or 50% is not something we or many other investors can handle. Investors that use a buy & hold approach, or that always maintain a certain level of equity exposure, will be faced with significant drawdowns at some point, and maybe many times during their investment horizon. When the pain of those large losses is too great, investors always sell out of their equity positions. They are then too gun-shy to get back invested after a recovery takes hold, and their investment portfolios never recover. That is the devastation we aim to avoid.

The frustration that we accept in our approach, in place of this type of devastation, is having whipsaw trades, negative trades, accruing losses in defensive positions waiting for a new uptrend, and sometimes missing out on upside when benchmarks are making new highs (e.g., the S&P 500 made a new high on March 11th when we were still defensive). While never fun, the frustrating times in our Trend strategies are more than worth it based on the long-term results. Portfolios compound at a higher rate of return when you have good upside participation and can avoid large losses. We like those better long-term results and can sleep easier with avoiding panic selling in bear markets, not worrying about making money on every trade, and not focusing too much on short-term results.

If you like that too and are interested in using our trend following strategies, you can reach out to Grant directly by email (grant@mscm.net). Grant manages various tactical and trend following strategies at McElhenny Sheffield Capital Management for individual investors and other registered investment advisors.

Lastly, in our January article we mentioned a version of our trend following strategy that uses leverage, called Trend X. In this strategy, we invest in the TQQQ ETF when our model calls for equity exposure. TQQQ is an ETF that delivers three-times the daily return of the QQQ (Nasdaq 100) ETF. Leverage can be a powerful tool but comes with additional risk and it exacerbates moves to the downside. We don’t think anyone should buy a levered ETF for long-term investing as the downside can be extreme. During the 2020 bear market, for example, TQQQ was down nearly 70%. In our Trend X strategy, however, we feel comfortable trading TQQQ because our model usually has us defensive during these extreme downside moves, and we get the benefit of the leverage compounding our returns in the uptrends. Below are the results of this approach, which provided a return of 101.1% in 2020, net of fees. This is a strategy that we can only offer to Qualified Clients, per SEC rules.

Dance with the Trend,

Grant Morris

With another year in the books, we think it is a good time to provide an update on our rules-based trend following strategies, and why we think they are a better approach to investing. Let’s start with a 2020 market recap.

A passive buy & hold investor in the S&P 500 saw their account grow 18.4% in 2020, while an investor with a traditional 60/40 allocation saw a 16.26% return. 

Must have been a great year for all investors, right? Not so fast. As we know, the annual return numbers never tell the whole story about the type of year investors had. The annual return is just the final outcome and shows nothing about how difficult either strategy was to stick with during the year. Nor does it reflect the investor anxiety felt during the year with the crazy news flow we are inundated with every day. It seems like in 2020, every news story that broke came with fear that markets would react poorly and sell off again. Would be great if we could just “blink” and have the annual returns locked in, but for better or for worse, we have to live through the day-to-day results of investing…and the market action in 2020 definitely supported the adage that “the days are long but the year is short!”

At its worst point, the S&P 500 was in a drawdown of 33.8% and the 60/40 portfolio was down 22.8%. Talk about some long days!

No one on that date (March 23rd) knew that the selling was over or that we were on our way to new all-time highs. Many expected the selling to continue, and even after the rebound started, investors were constantly scared of a bear trap where the market would reverse again and take another leg lower, as it has during many previous bear markets.

This didn’t happen though, and it seems like the market rarely does what people expect. The passive S&P 500 investor had to ride the market down almost 34% and continue to stick with their investment plan in order to rebound and achieve the full 18.4% for the year. That is not a ride we could have handled with our serious investment accounts (retirement and long-term savings), and we’re certain many other investors couldn’t either. There are always those that intend to stick with a buy & hold approach but can’t stomach the devastating losses of bear markets, which causes them to sell on the way down to stop the pain. They are then left trying to figure out when to re-allocate to equity markets or miss any chance of growth in their accounts. A 100% fixed income allocation probably doesn’t cut it for most.

Trend following, that focuses on reducing drawdowns while still attempting to participate in market upside, typically provides a much smoother ride for investors. It doesn’t require always guessing about what the market is going to do, rather it reads what the market is actually doing and acts accordingly. We always have a plan to get out of the market at predefined points during selloffs, and to reallocate to the market when a new uptrend is detected. Sometimes it works beautifully (like it did in 2020) and sometimes there will be whipsaw trades – accepting that fact, and sticking with it (discipline!), is the way to achieve the long-term benefits of the approach.

Below is a chart of the Nasdaq Composite showing when we were invested (green) versus defensive (red). 

Our trend following model achieved positive returns each month from January 2020 through August 2020. We successfully avoided the bear market and were able to get back invested in April to participate in the rebound. We got stopped out in early September and moved defensive, then had a whipsaw trade in both October and November, before getting fully allocated mid-November through the end of the year.

All of that resulted in being up 35.8% net of fees on the year in the main trend strategy we run for our clients, called Trend Plus. Below is the latest strategy sheet for Trend Plus that includes our verified performance since January 2017.  

If you are interested in incorporating our trend following strategies into your investment plan, you can reach out to Grant directly by email (grant@mscm.net). Grant manages various tactical and trend following strategies at McElhenny Sheffield Capital Management for individual investors and other advisors.

In the next article we’ll present the results of using our trend following approach with leverage – a strategy we call Trend X.

Dance with the Trend,

Grant Morris

As of this writing, Tuesday’s Presidential Election is still undecided, but one thing that seems abundantly clear to us, and should to you as well, is that people are not good at forecasting, predicting, or guessing reliably about the future. This clearly applies to politics, but also to the economy, the stock market, and most any other complex system with a lot of variables.

All of the pollsters, pundits, and newsrooms – the supposed experts on politics and elections – predicted a specific outcome in this election and they were all wrong. CNN predicted a blue wave and Fox predicted a red wave. There was no wave. Most polls showed Biden with a convincing lead across various states, leaving Trump with no path to obtain 270 electoral votes. The pollsters talked about the statistical significance of their models and how there was nearly a zero chance they would be wrong again, like they were in 2016. Guess what? They were wrong again, as both candidates still have a chance to win. Some polls will ultimately be correct on the final outcome of the election, but the guidance from the polls on how the election would unfold was basically worthless – so inaccurate that they should have left their guess up to a coin flip and avoided all the effort. People just aren’t good at forecasting.

Relating to the stock market, teams of analysts at investment banks and wall street research firms pump out reports on most publicly traded companies that include price estimates (i.e., guesses about future stock prices). They also try to predict where the S&P 500 index will be at certain points in time, what the economic data will reveal, what the Fed will do, where interest rates are going, and countless other variables. All of this is done in hopes of having an “edge” in the market and being able to perform better than an average passive “buy & hold” investor. These analysts and research firms never have to show their track record or what their success rate is across all their predictions. If they did, the very best of them would probably be about as good as a coin flip, but most would fare much worse. Of course, we’re just guessing about that too!

Investors that rely on these predictions to make investment decisions are fooling themselves about the reliability of the predictions. We think most investors know and understand this but choose to do it anyway for behavioral reasons. Making investment decisions about your own money or client’s money is difficult and emotional. If an “expert” provides some information about the future, it now makes it easier for you to rely on that information to support your investment decision. If you get lucky and the decision ends up being a good one, you feel great about your investment acumen and how you processed the information available to you that led you to that good outcome. If you are unlucky and the investment decision ends up with a bad outcome, you can easily lay blame to the expert and not yourself, protecting your fragile ego as an investor and allowing you to just move on to other experts that you hope will be better to rely on. This is a really bad approach and leads people to always underperform the market over long time periods. This applies to most active management that relies on stock picking (i.e., trying to pick the winning stocks and avoiding the losers in an effort to beat the benchmark). Ultimately, this is all guessing about the future and there is a lot of data and research that shows this is ineffective; the vast number of investors who attempt this get worse-than-benchmark performance.

What are the alternatives? One alternative approach is to just be a passive investor and stop trying to beat the market. This could be a good approach if you have a long investment horizon in front of you and, most importantly, have the ability to withstand everything the market is going to put you through. Remember though, a passive buy and hold approach will only work if you can hold through the major downturns and bear markets that are inevitable. Selling on the way down, when markets are falling and it feels like the world is ending, doesn’t get you those benchmark returns and probably causes you to miss some or all of the eventual rebound. I don’t think this is a good alternative for the vast majority of investors; most will ultimately panic sell when things get bad enough and the dollar value of their losses is too painful to withstand, and then they will be overly cautious about buying back in. It is very hard to allocate again to equity markets after selling out due to large losses. The fear of further losses can be overwhelming.

Another alternative, the one we think provides the best overall results to investors, is to stop guessing about what the market is going to do in the future and instead assess what you are going to do in the future, based on what the market is actually doing. Stop guessing and start assessing! Plan out your future investment decisions and distill them into a set of rules that can be applied to any future market environment. Then, when that market environment shows up, regardless of the reason or the cause of it, apply the rules to make your investment decisions.

This is exactly what we do through our weight of the evidence trend following model. It takes the emotional and difficult decisions out of the investment process and we never have to predict what the market is going to do.

We assess what the market is doing each day, determining if the market is in an uptrend and how strong it is, then, based on our rules, we decide to participate in the market or not. If the market is in an uptrend that aligns with our rules, we invest, and if the market sells off to certain levels, we move defensive. The “whys” don’t matter to our investment decisions and don’t have to be predicted by us. We don’t care if the uptrend is caused by a booming economy or by Fed stimulus. We also don’t care if a bear market is caused by an economic shutdown as a result of a global pandemic or because the financial system is on the brink of collapse due to a home mortgage crisis – both fairly unpredictable events. Our rules help us navigate the market environment as it comes; if the market does X, we buy, and if the market does Y, we go defensive.

If you can create a set of rules for yourself and how you want to approach markets and trading, instead of spending all your time trying to “figure out the market,” you will probably have much better results. If you are unable to create a set of rules, or maybe you’re unable to have the discipline to follow the rules that you created – find someone that can do it for you. Maybe that’s us.

If you are interested in incorporating our trend following rules into your investment plan, you can reach out to Grant directly by email (grant@mscm.net). Grant manages various tactical and trend following strategies at McElhenny Sheffield Capital Management for individual investors and other advisors.

Dance with the Trend,

Grant Morris

The S&P 500 recently got back to positive territory for 2020, with a year-to-date return of 1.4% as of July 22nd. It didn’t stay positive for long though. Trading was down on the 23rd and 24th, bringing it back into negative territory as of the end of last week, with a year-to-date return of -0.47%. Getting back to positive for the year does not mean this bear market is over; however, as the S&P 500 is still down about 5% from its all-time high set on February 19th. Buy & hold investors have now spent more than five months either losing money or trying to recover from those losses. We’ll have to wait to see how much longer the recovery will take. As we mentioned in the last article, if the S&P 500 fully recovers anytime soon, it will be in the books for the shortest bear market in history. The current shortest bear market in the S&P 500 was from February 1966 to May 1967; that one lasted 14.8 months.

The outperformance of trend following, over a buy & hold approach to investing, is usually very apparent during and right after a bear market. One of trend following’s major benefits and source of outperformance comes from avoiding large losses. If bear markets didn’t exist, there would be less of a reason to use trend following; passive investing wouldn’t suffer devastating losses and could be tolerated by most investors. Of course, bear markets do exist, and occur with somewhat regular frequency. Since the 1960’s the S&P 500 has had a bear market about every 7 years on average. If you are investing in stocks over a 30-year or more timeframe, you should probably expect to face at least four bear markets. The bull market returns can be great for passive investors, but those bear markets sure won’t be any fun. Also, the timing of bear markets in your investment timeframe matters a lot. Bear markets when you are in or near your retirement are much worse, as we’ll illustrate below.

The problem with bear markets is not only the size of the losses – or drawdown from peak to trough – but also the amount of time it takes to recover from losses. The time that it takes for your investments to get back to even after a major drawdown event is a huge drag on your psyche and can of course be detrimental to investing plans. If you’re fortunate to still be in the accumulation phase (working/saving years) and you experience a 20% drawdown, academic finance will say to stay invested so you can fully recover as the market does. Being down 20% means you need a 25% gain just to get back to even. The problem with drawdowns is exacerbated if you are at or near retirement. A 20% drawdown on your account balance while you are withdrawing retirement income could take much more than a 25% gain to get back to even, and it is highly dependent on the duration of that drawdown.

Let’s look at the impact of retirement withdrawals (“w/d”) on different investments during this current bear market (which may end up being the shortest in history). Chart A shows the S&P 500 Index (100% stock portfolio) and the Vanguard Balanced Index Fund (VBINX) – a proxy for the common 60% stock and 40% bond portfolio. 

Chart A

The darker blue and orange lines reflect starting the year with a $1,000,000 buy and hold account in each investment. The lighter lines, denoted with “(w/d 4%)” in the legend, reflect the same investment accounts, but money has been withdrawn each month based on a 4% annual withdrawal rate, which is a common retirement withdrawal plan. The horizontal black line is at $1M. While the 60/40 portfolio has recovered to back over $1M, the VBINX account with withdrawals has not – and this is over a very short timeframe of just six months. The two S&P 500 accounts haven’t yet recovered and the one with withdrawals is of course furthest behind.

In longer bear markets, the impact of withdrawals is magnified. Chart B shows the 60/40 accounts starting with $1,000,000 at the end of 2006, both with and without withdrawals, going through the 2008 bear market and recovery.

Chart B

The red dot on each line is the point prior to dipping below $1M and the green dot is when they recover to $1M. The period between the dots on VBINX was 19 months, while the period below $1M when you have withdrawals was 40 months – ouch! Withdrawing funds to live off of in retirement would have made your recovery take more than twice as long. If you were a 60/40 investor in retirement during this time period, you went more than 3 years without any portfolio growth, and you also saw the value of your portfolio drop 33% at its lowest point. Few retirees can withstand such devastating losses – most will quit while they’re down and never get the shot at recovering, maybe forcing them to drastically change their retirement plans – they may even have to come out of retirement.

Chart C shows the same for the S&P 500.

Chart C

The S&P 500 without withdrawals was below $1M for 33 months while the account taking monthly withdrawals took 64 months to recover (more than 5 years)!

Young investors may be able to tolerate such moves, but as you get older and your nest egg grows, it is much harder to do because the dollar values are so much more meaningful. Being down 20% on $1,000,000 (i.e., losing $200,000) feels a whole lot worse than being down 20% on $10,000 (losing $2,000).

We think a much better, more tolerable approach to investing when your nest egg becomes sizeable and your investment time horizon is shorter, is to use trend following. Trend following can be very powerful, as it will generally help to reduce the magnitude of your drawdowns and also the amount of time you spend in drawdown. This equates to more time making new money and higher compounded returns over time. It is also a great diversifier to traditional portfolios, as trend following rarely suffers underperformance at the same time a traditional portfolio is suffering losses. Below are the same three charts with the addition of our Trend Plus portfolio (Note that we always show modeled returns prior to 2017, as this exact strategy was not in use before that time).

Chart D

Chart E

Chart F

Like we said before, the outperformance of trend following over a buy & hold approach is usually VERY apparent in bear markets. It sure has been this year, with buy & hold still trying to recover while our trend following approach is at highs, with positive returns each month. Trend following is a risk management approach more than anything else – it attempts to participate in market upside when it can, but always with a focus on downside protection. If you’ve been investing for a while and are tired of traditional approaches to handling bear markets, maybe it’s time for you to take a different approach to investing. Show the old bear a new trick.

If you are interested in incorporating trend following or tactical investment management into your investment plan, you can reach out to Grant directly by email (grant@mscm.net). Grant manages various tactical and trend following strategies at McElhenny Sheffield Capital Management for individual investors and other advisors.

Dance with the trend,

Grant Morris