It has become a popular strategy over the past decade, and it does have some merit, but there are some serious pitfalls.
The strategy is to buy the SP500 when prices close above the simple 10 month moving average; the sell signal is a monthly closing price below the simple 10 month moving average. In all likelihood as the month nears its finale, the SP500 will close above its simple 10 month moving average thus triggering a buy signal.
This strategy has been popularized by Mebane Faber of the World Beta blog and others around the internet have taken up the mantle, as well. I would characterize the strategy as elegantly simple. But simple can be good too. The strategy does work and it works across multiple asset classes. It is easy to implement as you only have to look at monthly charts and ask yourself one question: where is price relative to the simple 10 month moving average? The strategy will keep you in bull markets, and by moving to cash when prices are below the simple 10 month moving average, you avoid the punishing draw downs (and higher volatility) of a bear market.
Ah, if only it were so easy. So what are the pitfalls?
First some numbers. Since 1960, this strategy generated 1565 SP500 points. Buy and hold SP500 netted 1265 points. The strategy generated 36 round trip trades over the years with 67% of the trades being winners. The average winning trade was almost 4 times as large as the average losing trade. The average trade lasted 13 months; the average winning trade lasted 17 months with the average losing trade going on for only 4 months. No trade loss more than 11% but only two trades had individual trade draw downs exceeding 15% (1990 and 1987). This means that 34 out of 36 trades had individual trade draw downs less than 8%. This is pretty impressive stuff. So where is the rub?
One concern I have with this strategy is how it made its money. There was one trade — from 1994 to 1998 — that was responsible for almost 33% of the points earned from this strategy. While we can argue that’s the luck of trading or how bull markets go, the reality is that one trade in 52 years was a statistical outlier. My question: do we want to have a strategy that is dependent upon capturing a statistical outlier to be responsible for that strategy’s success? The answer is “no”. We would prefer to have strategies that earn their gains on a consistent basis. If this one mega trade did not occur, it is very likely that this strategy would have underperformed buy and hold.
Another concern for this strategy is that it is not particularly efficient. By this I mean, individual trades can give up significant gains before being closed out. In other words, sell signals typically occur long after the market has peaked. This can be seen in the Maximum Favorable Excursion (MFE) graph. See figure 1. MFE, measures in percentage terms, how far a trade moves in your favor before being closed out for a loss or a win. So take the individual trade inside the blue box in figure 1. This trade ran up 39.45% (x axis) before being closed out for 31.05% (y axis) winner. We know this was a winning trade because the caret is green. The trade has an MFE of 32.69% but loss 8.40% before a sell signal was generated. Looking at the trades inside the oval, we note that they all ran up near 30% but gave up one-third of those gains before being closed out. Even the mega 1994-1998 trade (see orange arrow on chart) gave up over 50% in gains before being closed out. Ouch!
Figure 1. MFE Graph
In summary, there is a lot to like about this simple, easy to implement strategy. However, under the surface there are several “issues” that might make it difficult for investors to utilize and follow. Such is trading. The important lesson from this exercise is to avoid the big losses, and that is what this strategy does well.
What does this buy signal mean for the markets and economy? It probably is a signal that a recession has been averted (for now). It would be unlikely to have the economy in recession with prices on the SP500 above its simple 10 month moving average.
Category: Technical Analysis
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