The Complementarity of Trend Following and Relative Sentiment

Abstract

We investigate the complementarity of trend following and relative sentiment for equities. On the surface, the unconditional correlation of these strategies (0.69) is moderately high, suggesting little may be gained from combining them in a portfolio. Upon inspection, however, we find that relative sentiment tends to compensate for trend following’s two major weaknesses (namely, staying in the market too long after the market has peaked and staying out of the market too long after the market has bottomed). Likewise, trend following tends to compensate for one of relative sentiment’s main weaknesses—not being fully invested in equities during strong uptrends. As a result, a 50-50 combination of the two improves on the performance of each during their respective weakest periods, has a return distribution with thinner tails, and exhibits a lower tracking error to a hypothetical (perfect-foresight) strategy that consists of the maximum achievable performance from switching between the two strategies.

Keywords: Trend following, relative sentiment, tactical asset allocation, time-series momentum, market timing, wealth management, equities

JEL Classification: G10, G11, G14, G17