The 200-Day Moving Average’s Record as a Timing Indicator
Thursday, April 10, 2014

One strategy I have heard people discuss from time to time is using the 200-day moving average as a timing indicator. Stocks are purchased when a broad market benchmark is above its 200-day moving average, and stocks are sold when the market benchmark falls below its 200-day moving average. Though there are variations in the type of the moving average used, the basic premise is the same: Own stocks when the market is above the indicator and sell stocks when the market is below it.

In his new fifth edition of “Stocks for the Long Run” (McGraw-Hill, 2014), Jeremy Siegel looked at whether this strategy is beneficial. He ran the numbers from 1886 through 2012 using the Dow Jones industrial average. He applied a 1% band, meaning the Dow had to be at least 1% above its 200-day moving average to trigger a buy signal or at least 1% below its 200-day moving average to trigger a sell signal. The band is important because it reduced the number of transactions. Without it, an investor would be frequently jumping in and out, driving up transaction costs in the process. Siegel also assumed end-of-day prices were used.

Following the 200-day moving average timing strategy would have kept an investor out of the worst market downturns. Specifically, the investor would have avoided the large losses endured during both Black Tuesday (October 29, 1929) and Black Monday (October 19, 1987). The strategy would have also helped the investor avoid the 2007-2009 bear market.

Commenting on the results, Siegel observed, “The timing strategist participates in most bull markets and avoids bear markets, but the losses suffered when the market fluctuates with little trend are significant.” He added, “The timing strategy involves a large number of small losses that come from moving in and out of the market.”

Jeremy’s calculations show the 1886-2012 annualized return from the timing strategy dropping from 9.73% to 8.11% once transaction costs are factored in. In contrast, the buy and hold strategy realized a 9.39% return. If the 1929-1932 crash is excluded, the buy and hold strategy looks even better: A 10.6% annualized return versus annualized returns of 9.92% and 8.38% for the timing strategy (without and with transaction costs, respectively).

One advantage the 200-day moving average timing strategy did have was reduced risk. With the exception of 1990-2012, the timing strategy incurred less risk than the buy and hold strategy for every period and subperiod studied. This is due to the avoidance of the market’s big downward drops.

There is one consideration not factored into Siegel’s analysis: investor psychology. If an investor lacked cold-as-steel nerves and either failed to sell or buy stocks when triggered, the timing strategy’s performance would be much worse. This is because by not acting appropriately, the investor would have missed out on the benefits the strategy was designed to provide.

This is the inherent problem with all trading strategies. An investor who is psychologically unable to stick with them during turbulent market conditions is always better off with a buy and hold strategy. It does not matter how well a trading strategy has performed in the past; if an investor cannot stick to it in all market conditions, his portfolio will suffer. A simple formula to remember is portfolio return equals strategy performance less transaction costs and behavioral errors. A sound strategy that incurs the lowest combination of transaction costs and behavioral errors is the one that will allow you personally to realize the largest long-term gains.

NCAA Tournament Addendum

Three weeks ago, I wrote about the difficulty I was having with my NCAA Basketball Tournament picks. As it turned out, I was right not to have much faith in my predictions—I didn’t get a single Final Four team right. In my defense, CBS Sports described this year’s group of Final Four teams as the “fourth most unpredictable” since the field was expanded to 64 teams in 1985. The University of Connecticut’s men’s team also had the lowest KenPom ranking (25th) of any champion and the fourth-lowest of any Final Four team since data was compiled starting in 2003. (KenPom is a quantitative ranking based on both a team’s offensive and defensive play.)

This year’s tournament provided a great example of how difficult it can be to predict short-term events, especially those subject to unanticipated outcomes. It’s also evidence of why you should never make big bets if there is a likelihood of the future unfolding in a different manner than you expect.

(Congratulations to those of you who are UConn fans on both the men’s and women’s championship victories.)

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The Week Ahead

AAII’s Joe Lan will explain how to find a winning stock this Saturday (April 12) to our Research Triangle chapter. The meeting will be held in Cary, NC. Not in North Carolina? Visit our Local Chapters page to find an upcoming meeting near you.

Passover will begin on Monday evening. Happy Pesach to those of you who are observing the holiday.

The U.S. financial markets will be closed on Friday in observance of Good Friday. I know I’m a week early, but Happy Easter.

Federal and state income taxes are due on Tuesday, as are first-quarter estimated tax payments.

More than 50 members of the S&P 500, mostly mega-caps, will report earnings next week. Included this group will be Dow components Coca-Cola (KO), Intel Corp. (INTC) and Johnson & Johnson (JNJ) on Tuesday; American Express (AXP) and IBM (IBM) on Wednesday; and DuPont (DD), General Electric (GE), Goldman Sachs (GS) and UnitedHealth (UNH) on Thursday.

March retail sales and February business inventories will be released on Monday. Tuesday will feature the March Consumer Price Index (CPI), the April Empire State manufacturing survey and the April National Association of Home Builders housing market index. March housing starts and building permits, March industrial production and capacity utilization and the Federal Reserve’s latest Beige Book will be released on Wednesday. Thursday will feature the April Philadelphia Fed Survey.

The Treasury Department will auction $18 billion of five-year inflation-adjusted securities (TIPS) on Thursday.

April stock options will expire on Thursday, a day earlier than usual.

Local Chapter Meetings

AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!

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AAII Sentiment Survey

Pessimism rose to a nine-week high in the latest AAII Sentiment Survey. Neutral sentiment stayed above average for the 14th consecutive week, while optimism remained below average.

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 6.9 percentage points to 28.5%. This is the lowest level of optimism registered by our survey since February 6, 2014 (27.9%). It is also the fourth consecutive week with bullish sentiment below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 0.4 percentage points to 37.4%. Neutral sentiment is now above its historical average of 30.5% for the 14th consecutive week. This is the longest such streak since 1999 (15 weeks).

Bearish sentiment, expectations that stock prices will fall over the next six months, spiked 7.3 percentage points to 34.1%. This is the largest amount of pessimism since February 6, 2014 (36.4%). It also ends a streak of eight consecutive weeks with bearish sentiment below its historical average of 30.5%.

At current levels, bullish sentiment is right at the border of what we would consider to be a typical or an unusually low reading. The drop in optimism comes as the S&P 500 index fell by 2.3% and the NASDAQ lost more than 3.7% over a two-day period.

Some AAII members are fretting about the possibility of a market pullback, elevated stock valuations, the pace of revenue growth, the slow rate of economic expansion and Washington politics. Others remain encouraged by the overall upward momentum of stock prices, earnings growth, economic expansion, the Federal Reserve’s tapering of bond purchases and low interest rates.

This week’s special question asked AAII members how much impact the events in Ukraine are having on their six-month outlook for stocks. Nearly two-thirds of respondents (63%) said the events were having no to very little impact on their outlook. About 11% said the events were having a little impact, while 9% said the events were having some impact. Just slightly more than 5% said the events were causing them to be more bearish.
Here is a sampling of the responses:

  • “None, unless Russia becomes more aggressive.”
  • “Minimal at most.”
  • “Not much, it’s just a disturbing and sad mess.”
  • “None at this time.”
  • “Some. Clearly it adds risk.”

This week’s Sentiment Survey results:

Bullish: 28.5%, down 6.9 points
Neutral: 37.4%, down 0.4 points
Bearish: 34.1%, up 7.3 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%

Take the Sentiment Survey.