Effects of Market Volatility on Market Trend Strategies

Does market volatility predictably affect returns to simple moving average (SMA) trend-following strategies? In their November 2023 paper entitled “Market Volatility and the Trend Factor”, Ming Gu, Minxing Sun, Zhitao Xiong and Weike Xu investigate how stock market volatility affects multi-SMA trend factor profitability. They first assess significance of the trend factor premium, as follows:

• For each stock at the close on the last trading day of each month:
  • Compute SMAs of prices for lookback intervals of 3, 5, 10, 20, 50, 100, 200, 400, 600, 800 and 1000 trading days, and divide each SMA by the end price.
  • Starting five years into the sample period (1931), regress next-month stock returns on corresponding monthly SMA ratios over the past 60 months.
  • Average the SMA ratio regression coefficients separately over the past 12 months to estimate next-month coefficients and apply these coefficients to estimate next-month return.
• At the end of each month, sort all stocks into tenths, or deciles, based on estimated next-month returns and form a trend factor hedge portfolio that is long (short) the equal-weighted top (bottom) decile. The trend factor premium is the monthly gross return for this portfolio.

They then assess how trend factor hedge portfolio returns interact with monthly stock market return volatility (standard deviation of monthly value-weighted market returns over the past 12 months) by specifying volatility has high or low when its prior-month value is above or below the full-sample median. Using data for all listed U.S. common stocks, excluding those priced below $5 or in the lowest tenth of NYSE market capitalizations, during January 1926 through December 2022, they find that:

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