This year I’ve written a few times about using the 200-day Moving Average (200MA) as a market timing indicator.
Evolved Perspective on the 200-Day Moving Average
Since my last posts my appreciation for and complaints about 200MA have evolved. I previously wrote that if enough speculators begin blindly following the 200MA it could lead to market instability, reminiscent of portfolio insurance becoming so popular by October 1987. I since have realized there is a huge difference between following a 200MA trading rule and employing portfolio insurance: the portfolio insurance strategy calls for you to keep selling as the market falls while the 200MA rule calls for you to sell only once. That simple difference, I think, makes the 200MA potentially far less destabilizing than portfolio insurance.
Forget About Timing Returns; Focus on Timing Volatility
I’m more of a sigma guy than an alpha guy. Get the risk control right, I figure, and the returns should take care of themselves. Hence I much prefer to assess 200MA in terms of separating periods of higher and lower volatility than in terms of separating periods of higher and lower returns.
In that respect it seems to do an excellent job.
Below is a comparison of cumulative returns to SPY since inception in January 1993 between a Buy&Hold strategy and a zero trading cost, zero slippage 200MA strategy, where you hold SPY only on days following when the prior day’s close exceeded its 200MA (and otherwise earn zero on uninvested cash). Bottom line: depending on the endpoint, you get 70% to 130% of the Buy&Hold return while being invested only 2/3 of the time, for essentially 2/3 of the volatility.
Source: PortfolioWizards, Yahoo! Finance
Past performance does not predict future performance.
Watch Out: Spreadsheets Don’t Know When You Forgot to Offset Your Inputs
I cannot emphasize enough that any apparent return advantage or disadvantage seems to depend entirely on your beginning and ending points. End the analyis in February 2009 and 200MA seems like a can’t miss strategy; end it in February 2000 and you’re fired.
But cumulative returns aside, I have to admit its ability to sit out protracted periods of high volatility and drawdown is fairly convincing.
All that said, beware of making a rookie mistake. The earliest price available on Yahoo! Finance for SPY was January 29 1993, making November 11, 1993 the first trading date available with a 200-day average. This means the earliest you could have realistically executed a 200MA strategy would have been November 12, 1993, employing the 200MA threshold as of November 11, 1993. A rookie mistake would be to anchor the decision criterion for November 12 on the November 12 200MA, which of course you could not have known. While you might think a single day look-ahead bias might taint the results negligibly, the actual bias is, as Will Farrell would say, ginormous.
Assuming perfect foresight of whether the day’s closing price would be above or below the 200MA – an offset of only one row in your decision criterion – would have resulted in a simulation looking like this:
Source: PortfolioWizards, Yahoo! Finance
This illustration depicts a strategy result assuming perfect foresight, which is not and would not have been possible.
So, if you’re going to manage portfolio composition according to 200MA indications of higher and lower volatility, be my guest. Just make sure if you simulate a result too good to be true, it probably is.