When I was a young account executive with Merrill Lynch in the mid-1970's, I became friendly with the top producer in our office. One day he shared with me one of the secrets of his success – he would only promote stocks if a certain percentage of the Dow Jones Industrial stocks were above their 39-week moving averages. Very few people even knew what moving averages were back then, and there were no PCs for calculating them. So I dug up all the old stock charts I could find with moving averages on them and verified that this moving average filter was incredibly useful. Not long after that, I was accepted into the PhD programs at both the University of Chicago and Wharton. I turned them both down, based in part on the how well this moving average method had done. (I was also impressed with Bob Levy's research on relative strength momentum and the Nick Darvas book describing his remarkable success using rotational momentum.) The efficient market hypothesis, which said the market could not be beat using publically available information, was akin to religion in the academic world at that time. I had frightening visions of being burned at the stake in the University of Chicago quadrangle if I had gone there.
![.]()
Things have certainly changed since then. During the past 20 years, academics have found strong evidence of profitability using trend following methods, such as moving averages. As with momentum, behavioral finance is what led to serious trend following research by the academic community. A large body of research has now shown that price trends exist in part due to long-standing behavioral biases by investors, such as anchoring and hoarding. Price trends are created when investors initially under-react and subsequently over-react to information because of their strongly ingrained behavioral tendencies.
There are now over a dozen well-researched academic papers documenting extraordinary risk-adjusted returns from trend following methods. I will provide references in my new research paper on absolute momentum that I am finishing up on now. However, here are three excellent, recently released papers on the subject of trend following:
Market Timing with Moving Averages by Paskalis Glabadanis
A Century of Evidence on Trend-Following Investing by Brian Hurst, Yao Hua Ooi, and Lasse H. Pedersen
The first two papers deal with moving averages applied to U.S. stocks. The third is a simple white paper from the folks at AQR. It features time series (absolute) momentum applied to 59 markets in 4 asset classes: equity indices, bonds, commodities, and currency pairs. The authors use a weighted combination of 1, 3, and 12 month look back periods on data going all the way back to 1903. Their paper provides convincing evidence that trend following absolute momentum is just as robust and pervasive as cross-sectional relative strength momentum.
The expanded version of my paper, Risk Premia Harvesting Through Dual Momentum, shows that absolute momentum is actually more valuable than relative strength momentum. Both enhance returns, but absolute momentum is more effective in reducing expected volatility and drawdown. The best of all worlds is to use them both together.
