Lessons from One of the Most Popular Trend Following Strategies

Posted June 25, 2023

The latest round of improvements for the 3 Stocks to Wealth strategy on our sister site, investtobefree.com, are almost here!

The latest changes are slated to be live and available to new and existing subscribers after the July 4th holiday.

As discussed last week, some great improvements are being incorporated that can better limit drawdown, get better entry prices and better exit prices. These improvements will continue to make the strategy very simple and time efficient compared to just about any other successful strategy we have used.

Perhaps we can even top the 2,500%+ performance over the first 9.6 years while spending just 15 minutes on 1 day per week executing and managing trades!

One of the improvements mentioned in the last blog post is based on a careful study of thousands of the best earnings gaps over the past 2.5 years. Inflation could remain high for a while and we wanted to study what works best after blowout earnings reports during what could be a new era for the market with higher inflation and interest rates.

We found that many of these game changing earnings reports will generate a strong trend that lasts 3 to 5 days. So we are studying which days offer the most opportunities and using this data to determine the new day of the week the weekly update will be published.

But today we will discuss the best ways to reduce/limit drawdown while maintaining strong performance. We will do this by going over one of the most popular trend trading strategies.

The S&P 500 is Trend Following?

I would argue that the S&P 500 is one of the most popular trend following strategies of all time.

Why do we say this?

Well, the only reason a stock is in the S&P 500 index is if both the market cap is large enough and the business is profitable enough to make it into the top 500 stocks. If the business growth and market cap growth of a company does not trend strongly enough over the years, it will never overtake the other 500 stocks to be included in the index.

If the fundamentals of a company in the S&P 500 index trend lower long enough, guess what?

The price of the stock will go lower and therefore the market cap. Eventually, another stock will replace it in the S&P 500.

For a long time Tesla was kept out of the S&P 500. It was not until the company was profitable enough for enough quarters to be included in the S&P 500. So another company was kicked out to include Tesla.

So its a great way to constantly be in the top 500 US stocks that are consistently profitable enough to be included in the index. The stock has to be voted into the index by a committee which helps to keep a certain level of diversification although its fairly concentrated in tech at the moment due to its market cap weighting and strength in certain tech stocks.

The Problem with the S&P 500

Like any other index, the S&P 500 will trend lower with the rest of the market as the future outlook for the economy and corporate profits turn lower.

In fact, the S&P 500 has drawn down around 50% or more from the highs on a couple occasions over the past 25 years.

To try to reduce the impact from these epic market crashes, good strategies have been developed based on historical analysis of key moving averages.

One of the more popular ones is to exit the S&P 500 once the index drops below the 40 week moving average which roughly coincides with the 200 day moving average. Then re-enter the S&P 500 once the index closes back above the 40 week moving average.

Some lauded this approach because it beat the S&P 500 over around 90 years and reduced drawdown significantly. So the max drawdown was MUCH lower than just staying in the index while the returns were better. Imagine a much smaller drawdown during the financial crisis versus losing around half your money while actually attaining better returns overall.

However, after 2016 this performance deteriorated and after over 100 years the strategy without the 40 week moving average stop-loss outperformed. But not by much. And that does not include what you could make in a money market while you sit in cash and wait for the S&P 500 to close back above the 40 week moving average.

So its still a very attractive option for some.

The Problem with a Stop-loss

We applied the same 40 week moving average stop-loss approach to the 3 Stocks to Wealth strategy over the first 11 years from 2012 to 2022. The advantage of having the system live for over 11 years is that we can now study its behavior in different market and macro conditions including going from very low inflation to very high inflation like we have not seen in many decades.

The 40 week moving average stop-loss certainly significantly reduced drawdown but it also reduced performance somewhat. Similar to some of the more recent approximate 100 year back-tests for the S&P 500.

We then went back and tested different moving averages and found the ideal moving average level to stop out at for the 3 Stocks to Wealth strategy over the first 11 years. In addition, we found the overall percentage stop-loss to use for the strategy from the highs. In other words, the best drawdown total to use to make it even more straightforward.

Just like the 40 week moving average stop-loss for the S&P 500, this is more about sleeping better at night and being comfortable with amounts exposed to certain stocks and the overall market. Not about increasing performance (although this is a distinct possibility going forward especially given the current money market returns being around 5% for times when the strategy is below the key moving average).

Finding the “Perfect” Moving Average

Finding the perfect moving average to use is really about curve fitting historical data. Although testing a range of moving averages does give you a good idea of how much performance you typically give up to protect the downside over the long-term. Given the exceptional returns of the first 12 years of the investtobefree.com strategy, the performance tradeoff will be just fine for many.

The 40 week moving average stop-loss for the S&P 500 will usually work out great during years where the market is down a lot. However, other years you may wonder why you even used it as it will likely hurt performance at some point.

So its more about being comfortable being in the market while probably giving up a little of the upside even though the back-test showed an increase in overall performance. Historically, it has reduced the downside by a LOT for both the S&P 500 and the 3 Stocks to Wealth system. We saw about a 35% reduction in drawdown with greater overall returns by applying the moving average stop-loss.

In fact, the max drawdown was around the max drawdown for the Nasdaq over the 11 years on a week ending basis. It was less than the max drawdown for the S&P 500 over the past 25 years.

Introducing the Next Round of Improvements

We will be releasing this and the other improvements to an already very successful long-term strategy in a couple weeks.

Better exit and entry strategies, ideal stop-loss strategy for the system, the new day of the week it will be published to capture more big moves after game changing earnings reports, tips on what to do if you are too busy that day to enter/exit trades, and another surprise addition to the strategy.

This surprise addition will be perfect for those who want to hold the best stocks longer.

A special offer to try the service will also be announced next weekend. Check your inbox later this week for more details. In the meantime, you can learn more about the differences between the investtobefree.com and tradetobefree.com strategies in the following article.

The difference between investtobefree.com and tradetobefree.com