As computer-driven algorithmic trading becomes an increasingly more important factor in the market, the recent massive shift towards a bearish stance among a subset of these programs has worrying implications. “This is like the chaos bet,” according to Kathryn Kaminski, chief research strategist and co-manager of a managed futures portfolio at AlphaSimplex Group, as quoted by The Wall Street Journal.
“Pretty much any way you run the models, you end up net short a lot of asset classes," Kaminski added, noting that this is the biggest swing from bullish to bearish among trend-following algorithms since 2007 and 2008 (see below). That, of course, was the era of the subprime meltdown, the financial crisis, and the most recent bear market for the S&P 500 Index (SPX).
Trend-Following Strategies: Where They Are Bearish
Source: The Wall Street Journal
Significance for Investors
Trend-following investment strategies are computerized trading algorithms that base their buying and selling activity on asset price momentum. Trend-following algorithms "generally try to ride markets when they move strongly in one direction," is how the Journal puts it. Trading algorithms in general have been blamed for increasing market volatility, and for making market declines more severe by creating self-reinforcing waves of selling.
Overall, trend-following algorithms now have short positions in stocks, currencies and commodities, per research by AlphaSimplex. The investment advisory firm and commodity pool operator is a leading developer of trend-following programs. While these algorithms still have long positions in bonds, this represents more of a bearish flight to safety than a strong vote of confidence in that asset class, AlphaSimplex observes.
An example of the growth in trend-following programs is offered by Commodity Trading Advisors (CTAs), who often rely on them. They managed $357.5 billion as of the third quarter of 2018, up by about 36% during the past 10 ten years, per data from BarclayHedge cited by the Journal.
However, these strategies did not deliver gains in 2018. The Societe Generale SG Trend Index, which tracks the performance of trend-following funds, was up by 1% in December 2018 and down by 8% for the year. "A lot of trend-followers ended the year down because it was tricky to catch many trends," as Rufus Rankin, director of research and a portfolio manager at mutual funds company Equinox Institutional Asset Management, told the Journal.
Given that trend-following algorithms already have staked out short positions in various asset classes, some observers believe that they are unlikely to add significant additional selling pressure going forward. Meanwhile, the failure of these strategies to produce gains in 2018 casts doubt on their effectiveness going forward. "The story has been sold almost like a 2008 protection trade, but it's not necessarily true that they will offset the next crisis, because we don't know what that's going to look like," as Chris Solarz, managing director at investment advisory firm Cliffwater LLC, told the Journal.