Market Timing with Moving Averages
"The trend is your friend" or "Never fight the tape" are common expressions
to justify investing in trend following market timing systems. One of the most popular Trend
following Timing system is the Moving Averages Crossover.
Simply:
- buy when a short moving average crosses up a long moving average (Golden Cross)
- sell when a short moving average crosses down a long moving average (Death Cross)
A common combination is 50 days and 200 days for the short and long Moving
Averages respectively. Aggressive investors using the Nasdaq often use shorter
Moving Averages such as 25 days and 100 days.
The longer the Moving Averages, the fewer signals will be generated. From
1950 to 2004, the 50/200 Days Moving Averages system just produced 28 Buy and 28
Sell signals on the S&P500 or about 1 signal per year which is pretty low.
(see also
Market Timing performances summary).
An illustration of the benefit of Moving Averages as Timing signal is the Stock
Market in the 1970s. Here is how such system would have fared over 1967-1978
period when the S&P500 was going nowhere.
The system is in Buy mode in the yellow zones. During that 11 years period, the Moving
Averages system earned 3% annualized while Buy And Hold earned 0.8%.
Notice how the system never enters
the market at bottoms and never exits the market at tops. Moving Averages are
trend following systems: they are always late. This system is very effective in
powerful trends but ineffective in less pronounced trends because by the time
the system gives a signal, the trend may be reversing.
BUT as you can see, even in this 11 years long sideway market, Moving Averages
crossover is
quite effective. The reason is that even in a long sideway market, intermediate
powerful trends will develop. The system always avoid the sharp
Bear Markets. That's the beauty of
Moving Averages: they will always take you out of the Market before severe
losses. The Max drawdown during that time period was -11.1% in 1969 compared to -28.1% for the S&P500 in 1974.
More recently, the 50/200 Days Moving Averages Crossover system was completely out of the market in 2001 and 2002 when
the S&P500 lost -10% and -21.3% !
Now, Moving Averages have few drawbacks:
 They do not really provide superior Risk Adjusted Returns: they reduce
volatility but also returns. The 50/200 Days Moving Average system beats Buy And
Hold in only 47% of the years.
So why use Moving Averages ? Mainly for diversification purpose: it is a trend
following system while most other systems are not. In a powerful Bull Market,
nothing will beat Buy and Hold: the closest market timing system will be Moving
Averages. Similarly, in a powerful Bear Market, nothing will beat being out of
the Market (except short selling !): the closest market timing system will be Moving
Averages. So Moving Averages will help you at times: how many people got smashed
by Market Timing based on Interest Rates since 2000 ? Moving Averages have done pretty well.
They require constant Monitoring as opposed to others suggested simple timing systems. One possibility is to use a simpler system
based on monthly stock market data. Just collect the Market's close price once a month and then:
- Buy when the market is above the 10 months moving average (only 10 data
points because we use monthly data)
- Sell when the market is below the 10 months moving average
10 months is about 200 days so the system is more or less similar to the previous one but has the benefit that now
monitoring is just required once a month.
See also:
Momentum Stock Picking & Market Timing to
improve your Momentum Stock picks with Market Timing based on Moving Averages.
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