Nearly everyone in investing has heard the axiom: “the trend is your friend”. This popular rhyme is generally used to convey confidence in an investment theme, and underscore a historical penchant for price direction.
As a believer in trend following, I am drawn to moving averages and statistical evidence supporting my investment thesis. In my experience, these technical indicators can help serve as guideposts for making prudent investment decisions rather than ill-timed trades.
However, the reality of stock market trends is that they aren't perfect. They are prone to error when too much emphasis is placed in perfect timing and can be unreliable during periods of extreme volatility.
By examining the pros and cons of trend following, we can be better prepared to capitalize on its strengths and avoid its weaknesses.
Reasons to Love Trends
1. Trends are persistent animals that often represent long-term periods of consistent price action. This can provide confidence in a particular segment of the market based on knowledge of past performance with the expectation that it will carry forward into the future. For example, an upward sloping trend line, such as the 200-day moving average on the SPDR S&P 500 ETF (SPY), tells you that this basket of large-cap stocks has been moving higher for a considerable period of time. This can be considered a positive sign of strength.
2. A stock or sector that isn't showing a trend due to sideways or indecisive price action can be viewed as a warning sign. Avoiding areas of the market that aren't showing relative strength (or weakness if you are shorting) can be helpful when examining new opportunities. Waiting for an more established trend to develop or breakout to occur may provide enhanced confidence in a successful outcome.
3. Trends can help you avoid major corrections and bear markets. By implementing a sell discipline using the long-term trends of the market, you can avoid seeing a big chunk of your money disappear like many investors experienced in 2008. Managing risk is one of the primary reasons for the adoption of a trend following approach as a trigger for exiting stocks, bonds, or commodities.