How Trend Following Handles Market Shocks & Drawdowns

When we travel by air, my wife usually points out that she thinks it would be better if people by windows boarded first; that way, anyone in an aisle or middle seat wouldn’t have to keep standing up. Meanwhile, I think the Southwest Airlines style of pick-any-open-seat is optimal.

Our gut feelings were recently rendered irrelevant when we ran across an old episode of “MythBusters.” In it, the cast built a mock 173-seat aircraft and tested several boarding approaches using real people and luggage.

Relying on the data cut through our emotional biases. It also inspired me to take a similar data-backed look at a common question I hear about systematic investing: Is this style of investing capable of reacting fast enough to declining markets? Our team heard this question several times during late July and early August, as the S&P 500 experienced a decline of 8.5%.

To dig into that question, I think it’s helpful to first acknowledge that not every market decline is the same. Said another way, these are not synonyms: shocks, sustained declines, crashes, and bear markets.

Price Shocks vs. Sustained Declines

I think it’s important to distinguish between the two distinct forms of market declines: sustained declines in value and temporary price shocks.

Sustained declines can take several months or years to develop before reaching an eventual trough. The more common vernacular is bear market, and the importance of protecting capital during these times is well-understood.

On the other hand, a shock is a rapid decrease in the price of an asset, usually over a few days or, at most, a few weeks. To understand if it is as important to protect against these declines, I looked at the S&P 500 Index since 1950 and extracted data about the 20 worst weeks.

Exhibit A: Worst 20 Weeks for the S&P 500 (January 1950 to June 2022)

Week Ended On	Return for the Week	Preceding Drawdown
10/10/2008	-18.20%	-29.77%
10/23/1987	-12.20%	-16.06%
3/16/2020	-11.98%	-18.89%
9/21/2001	-11.60%	-28.47%
4/14/2000	-10.54%	-0.73%
3/12/2020	-9.51%	-10.70%
10/3/2008	-9.40%	-22.48%
10/16/1987	-9.12%	-7.63%
9/13/1974	-8.71%	-40.60%
11/21/2008	-8.39%	-44.20%
7/19/2002	-7.99%	-39.68%
9/12/1986	-7.91%	-1.32%
3/9/2020	-7.60%	-8.74%
6/30/1950	-7.58%	-1.34%
9/27/1974	-7.41%	-41.67%
8/5/2011	-7.19%	-17.43%
12/6/1974	-7.09%	-41.81%
3/6/2009	-7.03%	-53.03%
10/13/1989	-7.00%	0.00%
2/20/2009	-6.87%	-46.64%

Interestingly, price shocks were most likely to occur during one of the following:

1. A steady bull market
2. Deep within an entrenched bear market

You see in the data that 14 of the shocks, or 70%, occurred when the preceding drawdown (the percentage decline from the previous all-time peak to subsequent trough) was less than 2% or greater than 20%. In fact, seven of the 20 worst weeks (35% of the samples) occurred after the index declined approximately 40% or more from its recent peak.

Sustained Declines, Not Shocks, Are the Enemy of Compounding

Since so many price shocks took place when the market seemed to already be in decline, I examined this point further by reviewing the characteristics and timing of all drawdowns in the S&P 500 greater than 20% during the same time period.

Surprisingly (at least to me), the S&P experienced only 11 unique drawdowns of 20% or more during the past 70+ years. (I defined unique as a 20% or greater decline from the previous peak to the next high. Multiple recoveries that did not result in a new high before declining back below 20% only counted as one drawdown, and the date noted is for the first time there was a decline below 20%.)

Although only seven of the 11 cases are associated with a recession as defined by the National Bureau of Economic Research, nine took more than 100 trading days to develop.

Exhibit B: Characteristics of 20% or Greater Declines (January 1950 to June 2022)

Date -20% or Greater Was Reached for the First Time	Days to Reach -20% or Greater	Days to Recover	Recession?
2/22/1982	310	178	Yes
10/21/1957	305	234	Yes
1/29/1970	288	532	Yes
3/12/2001	242	1,561	Yes
11/27/1973	221	1,677	Yes
7/9/2008	188	1,188	Yes
8/29/1966	139	171	No
5/28/1962	115	319	No
6/13/2022	111	402	No
10/19/1987	38	447	No
3/12/2020	16	110	Yes

When you marry the information from both exhibits, you realize that eight of the top 10 price shocks hit in the time between when the S&P 500 developed a greater than 20% decline and when it subsequently recovered. For example, the -11.60% shock of September 2001 arrived months after the S&P 500 had already declined more than 20% (March 12, 2001) and long before the index finished its 1,561-day recovery.

To me, this data signals two important points:

1. Most bear markets don’t begin with a price shock.
   
2. Since most significant shocks happen during prolonged declines, asset managers and financial advisors should be more concerned with protecting against sustained market declines than managing the risk of each individual price shock.

The second point is one of those making sure to see the forest, not just the trees, things.

Historically, sustained declines happen slowly and without fanfare. They usually can be categorized into three phases, last longer than most people expect, and have a prolonged recovery. Consider the recovery times of 2001, 1973, and 2008 in Exhibit B. That’s an average of almost 1,500 trading days to recover. The price shocks that occurred in the latter stages of these three bear markets were not the best time to implement downside protection measures. Instead, downside protection would have been more meaningful if applied months earlier, as the market began its slow decline.

How Would Systematic Investing React?

With that background in mind, now comes the fun part: testing the question of whether systematic investing can react fast enough to declining markets.

Since the data thus far has established value in focusing on protecting against prolonged declines rather than arbitrary price shocks, I created an illustration that applied two trend-following methodologies to the time periods in Exhibit B:

1. Long-term system: If the 50-day exponential moving average (EMA) was above the 200-day EMA, this represented an “uptrend,” and the signal was to buy or hold. If it was below, it meant a “downtrend,” and the signal was to sell.
   
2. Intermediate-term system: If the 10-day EMA was above the 100-day EMA, the signal was to buy or hold. If it was below, the signal was to sell.

Here are the signals presented by each trend-following system during the time periods from Exhibit B:

Exhibit C: Trend Signals During 20% or Greater Drawdowns (January 1950 to June 2022)

Date of -20% or Greater	Long-Term Trend-Following System Signal	Intermediate-Term Trend-Following System Signal
2/22/1982	Sell	Sell
10/21/1957	Sell	Sell
1/29/1970	Sell	Sell
3/12/2001	Sell	Sell
11/27/1973	Sell	Sell
7/9/2008	Sell	Sell
8/29/1966	Sell	Sell
5/28/1962	Sell	Sell
6/13/2022	Sell	Sell
10/19/1987	Hold	Sell
3/12/2020	Hold	Sell

Now let’s bring everything together:

1. Sharp declines are rarely a leading indicator of future poor performance. Only the weekly declines from 1987 and the 2020 Coronacrash led to a drawdown greater than 20%.
   
2. Systematic investing signals flashed “sell” for most severe sustained market declines since 1950. In each case (sans 1987 and 2020), both trend-following signals resulted in exiting the market prior to it hitting a 20% drawdown.

What the exhibits appear to present thus far is that systematic investing can react fast enough to declining market environments, assuming your primary goal is to protect long-term compounding.

Optimizing Timeframe Selection

At Blueprint Investment Partners, we seek to provide financial advisors with strategies that help protect against market environments that are likely to cause their clients to go off track from reaching long-term financial goals. If we can dissect the markets to understand where the most problematic risks exist, that provides an advantage to us as an asset manager, you as an advisor, and your end clients.

As risk managers, it is also critical that we understand the types of markets in which we can expect to excel and those where we might lag. Doing so allows us to communicate with advisors so they can pass that knowledge on to their clients.

As it relates to temporary price shocks and sustained declines:

1. During sustained market declines, our process will usually meaningfully reduce exposure
2. During price shocks, our process may reduce exposure just before a rebound

Periods like the second scenario inevitably occur and highlight the tradeoffs associated with selecting timeframes for a systematic investing process:

• Use a short-duration timeframe that is informed by only a few days of price data, and you might experience some benefits by more frequently missing individual price shocks, but it may create short-term capital gains and noisy statements (higher turnover and transaction costs)
• Use a very long-duration timeframe, and you may experience a better tax profile but find you don’t get out of declining markets fast enough or, on the flip side, don’t get back in soon enough when markets recover or rally

Blueprint Investment Partners portfolios are constructed with a blend of three timeframes that attempt to maximize tax efficiency while avoiding conditions where price shocks matter most (i.e., large drawdowns):

• Intermediate-term: Uses 10- and 100-day EMAs
• Long-term: Uses 50- and 200-day EMAs
• Strategic: A portion of the portfolio is bought-and-held

We believe these timeframes help us ignore price shocks when they are market noise – such as what we saw in late July and August – while reacting in advance to shocks that are part of a longer-term market decline.

I hope the data in this blog has helped cut through any emotional biases you may have about market shocks and declines, just as “MythBusters” helped settle my wife and my lighthearted dispute.

Barchart.com, S&P 500 Index ($SPX), 7/16/2024 to 8/5/2024