On June 23, 2016, the UK electorate voted 51.9% in support of an exit from the European Union. This resulted in significant market turmoil over the following trade day. The voting outcome came as a surprise to many, who saw the exit as unlikely. Perhaps more surprisingly, medium- to long-term trend followers benefited from the announcement: the SG CTA Index increased 2.27%. Why? Were CTAs forecasting the event?
Qualitative examination of price movements suggests that markets were trending in the direction of the Brexit exit in the prior months. This is supported by systematic analysis over the same period. There are many ways to define the concept of “trend,” and while it is useful to visually examine the evolution of prices themselves over time, creating a trend metric has its own utility in terms of creating a less subjective view of market behavior. Signal-to-noise ratio (SNR), which attempts to quantify the strength of a price trend by looking at how uniformly it increases or decreases, is one such measure.
In terms of its computation, the SNR is simply the absolute price change over the lookback period divided by the sum of the absolute daily price changes. The lookback period of choice depends on the timeframe of interest. For medium- to long-term trend followers that can mean anywhere from 40 to 120 days. The closer the price path is to a straight line over that period, the higher the SNR. A perfectly straight line will have an SNR of 1, while a completely flat path will have an SNR of 0. Below are some examples with generated data.
For the purpose of the analysis in this article, we also are interested in the direction of trends and not merely the strength, so in this context a sign is applied to SNR: positive for when the price increases over the lookback period and negative otherwise.
In addition to the SNR, the net positions of a simple trend following system are included in our analysis. While the details of the system are beyond the scope of this article, for the most part these positions are in the direction of longer term price movements, and are not immediately responsive to shorter term rebounds and whipsaws. The entry points of this system’s positions line up closely with the SNR observed on those dates. In the following charts the roll-adjusted price of a representative set of futures contracts is plotted, along with SNR over several timeframes and the net position of the sample system. From this we can hopefully determine why CTAs benefited from Brexit.
Gold exhibited some choppy behavior characterized by changing dynamics. 2014-2015 resulted in a weak negative trend, followed by a strong reversal in 2016. This led to higher magnitude SNR values than seen in other commodities, sufficient enough to bring the net position of our sample system into positive territory. This rebound likely benefitted CTAs when gold appreciated 4.69%.
European equities, and to a lesser extent global equities, exhibited weak downward trends in the later part of 2015. The recent recovery boosted SNR in multiple timeframes, but long-term trend followers likely retained short equity exposure because of their longer lookback period. The Euro STOXX 50 did not rebound to the same extent as some other indices. Because of this signal it is probable that CTAs had mixed exposure going into Friday the 24th, but biased on the short side. FTSE 100 and Euro STOXX 50 depreciated -8.56% and -2.90% respectively that day, so a correctly timed position would have paid off significantly.
With currencies the story was more clear cut. The Yen appreciated this year relative to the US Dollar, after a flat period characterized by a low SNR in most of 2015. This resulted in moderately high positive SNR values and long positioning of the sample system. The British Pound has been weakening fairly consistently, and this also is true year-to-date. Both of these currency futures moved in the direction of their year-to-date trend.
Bond futures have been in an extended bull market. This is especially apparent from mid-2015 onwards. This is reflected by above average, positive SNR values over the same period. Bond prices rose sharply, with the EUREX Euro-Bund increasing 1.24% and the CBOT 10-year note rising by 1.19%.
In the table below, we compare the sign of the 120-day SNR, at the time our sample trend following system entered its current position, to the direction of the move on Brexit. As expected, the direction and strength of the trend lines up with the trades the trend following system made. This supports the notion that, while CTAs were correctly positioned for Brexit, their exposure was dictated by trends that originated well prior to the actual event.
While it is tempting to claim that CTAs correctly predicted Brexit coming to fruition, it is more accurate to state that their positions simply reflect longer term trends in the futures contracts they trade. It is possible that as Brexit became more probable, the effect of its outcome became slowly reflected in market prices, resulting in the appearance of the aforementioned trends. This reasoning likely overstates the effect of a singular event. Regardless, SNR and simple qualitative analysis can shed light into the decisions made by CTAs and help to explain the effect of their stances during key events.
Rotella Capital Management anticipates the remainder of 2016 will occur as we describe, but note that unexpected events could change our outlook. We are still bullish on interest rates but this could be the last hurrah for a long time as we should be getting close to a secular bottom in interest rates. The dollar may rise and appear to be a temporary “safe haven.” Most commodities should continue on the deflationary path except for the metals which should continue to rise. Though we are still long-term bullish on stocks the equity markets may encounter strong headwinds in the next 6 months and we are neutral to bearish.