StockWatch
Reports of Its Demise Were Premature
Are trend-following systems based on moving averages as effective today as in the good old days?
This is an important question because such systems largely failed during the mid to late 1990s, prompting some to speculate that they would not work in the future because too many investors had started to follow them.
Fortunately, for this column, I obtained some updated data, courtesy of a study that calculated the 200-day moving average’s track record back to 1979, nearly 30 years ago. The study shows that the moving average’s failure in the 1990s was merely temporary; in this decade, it has reverted to its longer-term pattern of success.
The study was conducted by Ned Davis Research for the Israeli-based Psagot Mutual Funds, which, in turn, shared the study with me. The study encompassed the period beginning in late 1979 and lasting until last week, over which time, buying and holding the S&P 500 index (TICKER:SPX) produced a 10.2 percent annualized return.
In contrast, a strategy that switched between the S&P 500 and commercial paper, according to whether the S&P 500 was above or below its 200-day moving average, produced an 11.0 percent annualized return. And, not only did the strategy make more money than buying and holding, it did so while being significantly less risky than the overall market. That’s a winning combination.
There’s more than one way of measuring the extent to which this strategy reduced risk, of course. One is simply to look at the percentage of time that it was out of the market, which turns out to be approximately a quarter of the time. Another is to measure the volatility of returns; according to Ned Davis Research, the standard deviation of the moving average system’s annual returns is 13 percent less than for buying and holding.
What about the moving average’s performance this decade? From January 1, 2000 through last week, the 200-day moving average strategy analyzed by Ned Davis Research beat a buy-and-hold by 1.8 percentage points per year, on an annualized basis. And, it did so while being out of the stock market nearly 40 percent of the time. The volatility of its returns this decade was 35 percent less than for buying and holding.
In other words, the 200-day moving average system has performed better this decade than it did on average over the previous two decades.
This finding prompted me to check in with Blake LeBaron, a finance professor at Brandeis University who has extensively studied moving averages as a market timing tool. He said that the apparent success of the moving average system in the stock market this decade would certainly seem to cast doubt on one of the hypotheses that had been advanced in the 1990s for why the system was lagging the market. The hypothesis was that the system had become a victim of its own success, with too many investors following it and, thereby, discounting away any profits that it would otherwise have produced.
Instead, Professor LeBaron indicated that the moving average’s success this decade now makes an alternate hypothesis more likely: That the decade of the 1990s was merely an exception to the longer-term rule. That would certainly stand to reason, of course, because moving average systems have a particularly hard time when the market is going up -- any time spent out of the market will lead to market-lagging performance.
The bottom line: Don’t count the moving average system out for timing the stock market. There is no evidence that its performance this decade is any less impressive than its long-term record.
Mark can be contacted via email at mhulbert@marketwatch.com.
