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Hickory, dickory, dock,

Investors moved into stocks;

The trend turned down,

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They ran into bonds,

Hickory, dickory, dock.

Investors who scurry like frightened mice from stocks to bonds, and back again, rarely succeed. But disciplined trend-followers might be able to have the cheese offered by bull markets and eat it while avoiding downturns.

The historical record contains a feast of possibilities for trend-followers. But I’ll focus on Canadian stocks and Canadian bonds today.

They’re represented by the total returns of S&P/TSX Composite Index and the FTSE TMX Canada Universe Bond Index.

The Canadian market served up a big surprise over the years. Be warned – if you’re a stock investor, it might give you the heebie-jeebies.

Simply put, Canadian bonds outpaced Canadian stocks over long periods.

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The Canadian bond index advanced at an average annual rate of 8.6 per cent from the end of 1980 to the end of September, 2018, while the stock index climbed by 8.3 per cent annually.

Stock investors took a huge amount of risk over the nearly 40-year period. They experienced six big bear markets along the way, only to wind up doing worse than bond investors. Life hardly seems fair – but investors learned as much from childhood fairy tales and fables.

Mind you, the period covers a giant bull market for bonds. It started when interest rates were sky-high in the early 1980s and ended after rates slid down the market’s beanstalk to unexpected lows in recent years.

Bond investors now face less than promising prospects. The iShares Core Canadian Universe Bond Index exchange-traded fund (XBB), which follows the bond index, had an average yield to maturity of 3 per cent at the end of September. The yield represents a guess at the index’s likely average return over the next several years. In other words, bonds are unlikely to generate 8-per-cent annual returns.

The extraordinary record is just the start of the tale. Now imagine a trend-follower who put all of their money into either the stock or the bond index each month. They moved into stocks when stocks outpaced bonds over the prior 12 months. They ran into bonds when stocks underperformed.

For instance, at the end of September, the bond index had climbed 1.7 per cent over the prior 12 months and the stock index was up 5.9 per cent.

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As a result, they would have put everything into Canadian stocks for October. (The iShares Core S&P/TSX Capped Composite Index ETF (XIC) is a good way to invest in the stock index.)

The trend-following method as described generated average annual returns of 10.7 per cent from the end of 1980 to the end of September, 2018. It beat the bond index by an average of 2.1 percentage points annually and the stock index by 2.4 percentage points annually. (All of the returns herein include reinvested dividends, but they do not include fund fees, commissions, taxes or other trading frictions.)

The return boost from trend-following might look as appealing as a shiny red apple. Not to worry, I don’t think it’s poisoned, but it might be a little wormy.

Problem is, with the six big bear markets in Canada over the period, it turns out the trend follower jumped out of stocks 21 times. Much like mice running up and down the clock, they were overactive – and frequently wrong. While timing saved them when it really mattered before big downturns, it also served them poorly in choppy bull markets when they lagged.

If you’re like me and are as active a trader as a lazy cat is a mouser, you’ll be content to watch the markets scurry to and fro. But those who are more active should perk up because Canadian stocks have underperformed over the past 12 months. If the current downturn becomes more serious, they’ll be sitting safely on the sidelines. On the other hand, the bear market may prove to be little more than a fairy tale – this time around. Only time will tell. Hickory, dickory, dock.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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