Can Trend Following Survive Stagflation
In our earlier post on Stagflation, we have laid out what is stagflation and how it affects major asset classes. In short, stocks and bonds still delivered positive nominal gains but lost out to inflation. Gold managed to beat inflation although it did so with huge volatility. I'm not going to dwell on the topic of stagflation in this post but my interest is more in whether one of the strategies we teach can survive stagflation. The strategy that I'm going to focus on is Trend Following. The strategy that we teach is 100% focused on stocks so let's zoom in and look at how the S&P 500 performed during stagflation. Just like in the previous post, I have included the estimated dividends for S&P 500. I used S&P 500 as the proxy for stocks because this is one of the few stock indices with a publicly available price history going back to the 70s.
Not A Pretty Sight
The only good thing you can say about the S&P 500 during this period is that if you had the fortitude to hang on for a long period, you still made money on it but only in nominal terms. As the previous post alluded to, in real money terms, the S&P 500 still lost money. In any case, most people only think in nominal terms so let's stick to that. Still, it wasn't pretty. The S&P 500 suffered from three major dips, -36% in 1970, -48% in 1974, and -27% in 1982. There were two back-to-back double-digit annual losses in 1973 and 1974.
What About Trend Following?
Given the backdrop for stocks above, how would Trend Following fare? As our students would know, the Trend Following strategy is applied to the Dow Jones Industrial Average Index component stocks. Ideally, we should also want to apply the strategy to the exact component stocks present in the index back then. However, there had been quite a bit of component changes since then and many of the original component stocks are no longer around today. They may have either privatized or merged with other companies.
What I have done is to include as many of the companies that had been a part of the Dow Jones Industrial Average at one stage. The important criteria is that they must all have historical prices going back to the 70s. I then looked for other existing listed companies that have been trading for at least most of the 70s period to make up the rest of the 30 component stocks. Below are the final 30 component stocks that I came up with.
Result (Not Too Shabby)
After arriving at the 30 stocks to form the stock universe for Trend Following, I proceeded to run the simulation on these 30 stocks during the 70s. Below is the simulation performance.
Trend Following did better than S&P 500 by being defensive during severe stock market downturns. During those major dips in the S&P 500, Trend Following went through a much less severe maximum drawdown of 15% to 18%. Although Trend Following also suffered annual losses in 1973 and 1974, the annual losses were all in the low single-digit. Due to the defensive nature of Trend Following, it made more money than S&P 500 for the entire period, all without using any leverage. Trend Following was able to beat inflation marginally by generating a nominal compound annual growth rate of 8%.
A More Recent Example
Much as we'll like to think of Stagflation as a unique market environment, it is actually not too different from any other run-of-the-mill recession, at least in nominal terms. In fact, the 2008 Great Financial Crisis (GFC) impact on the S&P 500 is pretty similar to the effect of Stagflation as seen below.
The only difference between the two periods is that while there were three major dips during Stagflation, there was only one major dip during the Great Financial Crisis where the S&P 500 lost 57%. But the common feature among all the dips is that they all evolved slowly over a few months, giving sufficient time for any long-term trend following strategy to adapt. Let's take a look at how AllQuant's Trend Following strategy performed during this more recent GFC period.
The picture is similar to the one for Stagflation. Trend Following was also defensive during the Great Financial Crisis due to its ability to go to cash when stocks are going down. This more recent example of Trend Following performance gives us more confidence that the simulated performance during Stagflation in the 70s is valid due to the nature of how Trend Following works. Of course, if anyone can think of a more representative stock to include in the 70s simulation, do let us know and we can make a change to see the result.
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