Market Returns - Simple Improvement

The lagging relationship provides the key to using a moving average as a filter or a permissioning switch. If you believe most financial assets tend to trend, then a moving average identifies the trend. If prices are lower than the moving average, then the market is deemed to be in a downtrend. If above, in an uptrend.

Whipsaws, where prices cross above one bar and below on another, can be a problem because they produce a lot of short in and out trades. To avoid the whipsaw effect, some traders require two or more closes above or below before any action is taken. The shorter the timeframe (one-minute bars, 1-day bars, 1 week-bars), the more likely the whipsaws.

In the case at hand, we trade monthly bars. Each trade occurs at the end of the month. Our approach is to accept whipsaws rather than to screen for them. To screen using monthly bars would mean to postpone the decision by one or two months.

Applying A Moving Average

Here is a visual of SPY monthly data and a moving average of 10 (months) for SPY (an ETF for the S&P 500):

(Click on image to enlarge)

The chart shows how the Simple Moving Average (SMA) moves with respect to prices. The trending aspect of the S&P is obvious. To use this simple moving average, you would set a decision rule. Usually, SMA decision rules are set in terms of the slope of the moving average or when a close crosses above or below the SMA.

For testing purposes, the diversified market index VTSMX, a Vanguard mutual fund used in prior analyses, is used to test the efficacy of an SMA market filter. The 10-period monthly simple moving average (SMA) was used. (Note, 10 months on a monthly chart is nearly equivalent to the popular 200-day moving average on a daily chart.)

No diversification was involved except that contained within the VTSMX mutual fund itself. All funds are either in VTSMX or in cash (actually a short-term interest-bearing fund).

The Decision Rule

If the close of VTSMX is above the SMA at the end of a month we stay in the market (or enter if we have been out). Conversely, when a close is below the SMA at the end of a month we go to cash or stay in cash if we were already there.

It is in this respect that the SMA acts as a permissioning switch. The switch is on when closing price > SMA (you are in the market). When the switch is off, you are in cash. The switch is evaluated at the end of every month and action is taken as necessary.

The Results

The effects of using the switch (Timing Portfolio) versus a buy-and-hold strategy based on the 10 mo. SMA are shown below:

(Click on image to enlarge)

The results are spectacular. Using the switch takes the user out of most of the two devastating (50% drawdowns) periods above. The switch produced these improvements:

  • Higher total earnings (1.1 million vs. 90o thousand for the buy/hold strategy)
  • Higher CAGR ( 10% vs 9%)
  • Lower Standard Deviation
  • Substantially lower drawdown (18% vs 51%)
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