Ever since computers became mainstream and numerous financial websites began offering stock charting, monitoring stock prices and their moving averages (MA) has never been easier. With the exception of Commodity Trading Advisors (CTAs), who routinely use moving averages to identify trends, few Wall Street portfolio managers admit to utilising technical analysis, let alone using moving averages to formulate trading decisions.
For decades academics have been biased against the merits of technical analysis. This is primarily because the efficient market hypothesis – a popular albeit controversial theoretical framework – has suggested that historical price information is useless in predicting future price movements.
But today the tide is changing, and more academics and practitioners are embracing the use of moving averages as an effective tool in generating solid risk-adjusted returns, and more importantly protecting against large protracted losses.
Moving averages are statistical tools used to smoothe out historical price data. For example, the 200-day simple MA, an indicator often cited by financial practitioners, averages the closing price of, say, the S&P500 Index over the last 200 days. An MA moves forward always dropping the last day in the sample. If Apple today is trading at $115 a share, and its 200-day moving average comes in at $110, trend followers would own Apple stock since it was trading above its MA. Conversely a close below the MA would imply a sell signal.
More academics and practitioners are embracing the use of moving averages as an effective tool in generating solid risk-adjusted returns
Mebane Faber’s A Quantitative Approach to Tactical Asset Allocation has been one of the most downloaded papers on the Social Science Research Network website (www.ssrn.com). He compared buying and holding the S&P500 Index versus market timing using an MA. His approach consists of buying the S&P500 Index if its monthly close is higher than its 10-month simple moving average or staying in cash if the monthly close is below the MA.
The results are impressive. Had $100 been invested in the S&P500 Total Return Index in 1901 using a buy-and-hold strategy, $2.2 million would have been generated by 2012. On the other hand, over the same period the monthly MA market timing system would have returned $5.2 million.
More importantly, market timing would have resulted in 50 per cent less volatility and a 66 per cent lower maximum drawdown (loss). The aforementioned approach would have kept investors out of the market for all of the S&P500’s 1931 44 per cent plunge, and the 2008 37 per cent sell-off.
Faber says using monthly moving averages to time a basket of uncorrelated assets, from bonds to commodities to real estate, improves returns, lowers volatility and drastically decreases drawdowns compared to buy-and-hold.
In his book Stocks for the Long Run, Jeremy Siegel – the famed Warton Business School finance professor – makes a strong case for using the ubiquitous 200-day moving average. He applied a 1 per cent filter, meaning that prices had to close at least 1 per cent above or below the daily MA for a signal to be generated. He found the 200-day moving average has historically generated superior risk-adjusted returns and kept investors out of some major bear markets.
Even the legendary hedge fund manager Paul Tudor Jones claims to follow the 200-day MA. He once said: “You don’t need to go to business school, you’ve only got to remember... you always want to be wherever the predominant trend is.”
The attractiveness of using a moving average system is that it objectively identifies the predominant trend.
It should be noted that trend following can pose challenges, considering markets don’t always trend. When markets aren’t trending they are said to be mean-reverting or in a trading range. MA systems and trading ranges don’t mix well, generating ineffective signals, losses and lots of frustration.
Deciding on the best MA to incorporate, i.e. 40-day versus 200-day is, at best, guesswork. However, on balance a discip-lined approach to market timing with moving averages should keep us positioned in the direction of the predominant trend, allowing us to observe the old Wall Street idiom – the trend is your friend.