June Trend Model report card: Back on track at +5.1%

This is the latest performance update on my long-short account based on my Trend Model signals (see An intriguing Trend Model interim report card). After a period where the Trend Model strategy experienced some difficult drawdowns, the trading account rose 5.1% in June; the one-year return was 25.8%; and the return from inception of September 30, 2013 was 22.5%.

I reiterate my disclaimer that I have nothing to sell anyone right now. I am not currently in a position to manage anyone`s money based on the investment strategy that I am describing.


Trend Model description
For readers who are unfamiliar with my Trend Model, it is a market timing, or asset allocation, model which uses trend following techniques as applied to commodity and global stock market prices to generates a composite Risk-On/Risk-Off signal (risk-on, risk-off or neutral). I have begun updating readers on the Trend Model signals on a weekly basis and via Twitter @humblestudent as new developments occur.

The chart below shows the actual (not back-tested) changes in the direction of the signal, which are indicated by the arrows, overlaid on top of a chart of the SP 500. You can think of the blue up arrows, which occurred when the trend signal changed from negative to positive, as buy signals and the red down arrows, which occurred when the trend signal changed from positive to negative, as sell signals.

Trend Model Signal History

A proof of concept
While the results from the above chart representing paper trading is interesting, there is no substitute for actual performance. As a proof of concept, I started to manage a small account that traded long, inverse and leveraged ETFs on the major US market averages and, on occasion, sector and industry ETFs. Trading decisions were based on Trend Model signals combined with some short-term sentiment indicators. The inception date of the account was September 30, 2013, For more details on how the Trend Model or how the account is managed, see my post Trend Model FAQ).

When evaluating the performance of this trading account, keep in mind that this is intended to be an absolute return vehicle. While I do show the SPY total return, which includes re-invested dividends, for illustrative purposes, the SP 500 is not an appropriate benchmark for measuring the performance of this modeling technique.


Returns were too good to be true
I had expressed my concerns in the past that Trend Model returns have been too good too be true. From some of the feedback that I had received, it was evident that expectations were driven up to excessively high levels. The 30-40% returns seen were supported by a stock market that went steadily up without a correction for several years.

My best guess of a sustainable long-term return for this strategy is in the 20-25% range.

The recent drawdown experience had been painful.  But for some context, here is what Peter L Brandt had to say about evaluating trading strategies in light of drawdowns:

Drawdowns are a fact of life for a trader. They happen. There will be bad days and bad weeks and bad months, and periodically even a bad year. A losing day/week/month is not an indictment against a trading plan. In fact, drawdowns are to be expected and a trader must learn to take them in stride without pulling the escape hatch whenever a position turns into a daily loser.

A benchmark metric maintained by many professional traders is their Calmar ratio. The Calmar ratio is calculated by dividing the worst drawdown (month-ending basis) into the average annual rate of return for some measure of time. A rolling three-year period is the most frequent time measure for determining Calmar. A Calmar ratio of 2.0 is considered outstanding — 3.0 is world class. Some short gamma traders (naked options sellers) can generate Calmar ratios of 5.0 or even higher — that is, until they go broke, which they eventually will.

The practical implication of a Calmar ratio of 2.0 is that to achieve an average annual ROR of 30% you will likely experience a worst-drawdown of 15% or greater (month-ending). Keep in mind that a month-ending worst drawdown of 15% probably equates to a week-ending worst drawdown of 20% or greater.

The maximum drawdown experienced by this strategy was -15.5%. I don't have a three-year track record, but using the return from inception of 22.5%, that makes a Calmar, or a gain-to-pain, ratio of 1.5. That's not bad in light of Brandt's comments.


Strategy characteristics still promising
Overall, the returns of this strategy remains promising:

• The Calmar ratio is 1.5, which is still pretty good (see previous discussion)  By comparison, the drawdown for equities was in the order of 50% and most balanced funds saw losses of about 20% during the 2008-2009 period. Using even a 1 to 1 Calmar ratio and working backwards, it would be hard to envisage long-term return expectations of 50% for stocks and 20% for balanced funds today.
• Long term returns are respectable, despite the recent volatility. The one-year return was 25.8% and return from inception (September, 30, 2013) was 22.5%.
• Returns are highly diversifying compared to major asset classes. They are uncorrelated with equities (correlation of -0.24 with SPY) and bonds (0.02 with AGG).
• Returns are consistently positive, with a 67% monthly batting average.

An acid test year

The market environment in 2015 has been challenging for the Trend Model trading strategy. So far, the Greek induced market turmoil is starting to look like a repeat of 2011, when stock prices fell dramatically in August and chopped around for about two months before beginning a volatile recovery. Trend following models don't perform well in such choppy periods. I will therefore be watching closely how the model behaves during what will likely be stressful conditions.

To summarize, investment results this year have been challenging but continue to be promising for this model longer term. I am comfortable with attributing the recent return hiccup as a characteristic of a difficult environment for this class of model, rather than anything fundamentally wrong with the modeling approach. Readers who want to monitor the signals of the Trend Model to subscribe to my blog posts here, which include Trend Model updates, or follow me via Twitter @humblestudent.