The Dow Jones Industrial Average surged to new highs again last week cracking through the 15,000 level in the process. With the Dow up 14.3 percent already this year, many investors I talk to, both retail and professional, are scratching their heads about the durability of the stock market’s rally.
After all, the Dow has added two-thousand-five-hundred points in less than six months against a steady backdrop of negative economic news and scary headlines about slowing growth worldwide.
This just reinforces the fact that markets often defy logic (and gravity) in their movements, crossing up investors who are more focused on the fundamentals, which are often backward looking. That’s why having a simple but effective method to evaluate the market trend is essential in this, or any environment.
One time-honored method for determining market trends is based on simple moving average analysis. Timing your buy and sell points based on whether the current price is above or below a moving average of prices has proven very effective for participating in the majority of up trends, while avoiding severe losses during bear markets.
|Two simple trend-following rules can help you participate in bull markets, while avoiding losses in bear markets.|
And there is plenty of historical evidence to back up this claim.
In a paper published by the Journal of Wealth Management money manager Mebane Faber showed that, by following a mechanical moving average system investors could remove emotion and subjective decision-making from the investment process, which often results in poor timing. At the same time, investors can expect to earn superior absolute and risk-adjusted returns, according to Faber’s study and prior research as well.
The trading rules he presented are simple and can be applied to any market index (or index-tracking ETF):
Rule 1. BUY when monthly price rises above the 10-month simple moving average of prices, and
Rule 2. SELL and move to cash when monthly price falls below the 10-month simple moving average of prices.
That’s all there is to it.
Testing these trend-following rules on the S&P 500 Index from 1900 through 2008 shows eye-opening results (see graph above). The trend-following, moving average strategy resulted in 10.45 percent annualized returns, compared to just 9.21 percent for buy-and-hold, AND with far less volatility to boot!
Of course there are some drawbacks to moving average analysis. First, it never gets you out at the exact top or back in at the absolute bottom. Also, it can produce the occasional whipsaws (inaccurate buy or sell signals), such as we’ve experienced during volatile financial markets in recent years.
Moving average analyses, like other trend-following indicators, have proven to be effective tools because they are based on simple human nature.
People imitate successful behavior. When they hear “favorable news” about a particular stock or the overall market, they are inclined to follow-the-crowd and buy. As a stock or the market’s uptrend becomes established, more investors are attracted by the positive performance and jump on board to follow the trend.
Of course eventually the trend reverses, perhaps due to the normal expansions and contractions of the business cycle, or a specific negative event. The trend gradually turns the previous buying momentum into selling momentum.
But the trend-following investor may have the advantage of spotting a reversal early by monitoring moving averages, and sell before a more sizeable price decline.
By the way, according to this simple trend following system, as of April 30, 2013, the Dow remains on a solid 10-month moving average BUY signal!