“Whether a stock or index is trading above or below its moving average means absolutely nothing. Focus instead on the slope of that average. That is what works in markets.” – Trading Folklore

Strong opinions, strongly held. Without any basis in evidence or fact. Unfortunately, that’s how much the investment pundit industry operates, giving false hope to their acolytes that there indeed a holy grail that works all the time.

I want to focus today on the mythical powers that some seem to ascribe to the slope of a moving average.

In its basic form, a moving average is a simple technical tool that smooths (takes an average of) prices over some time period. In the stock market, the most commonly referenced time period is 200 trading days.

The slope of the average goes one step further, measuring the change in the moving average itself. If the moving average today is at a higher level than yesterday, the slope is said to be positive, and if lower, negative.

Earlier this year, we wrote a research paper (“Leverage for the Long Run”, click here to download) that dispelled some popular myths about moving averages and leverage. In the paper, we also illustrated the results of a strategy that moved into Treasury Bills when the S&P 500 closed below its 200-day moving average and into the S&P 500 after closing above it.

Going back to 1928, an unleveraged version of this strategy would have generated an annualized return of 10.8% versus 9.1% for a buy-and-hold of the S&P 500. More importantly, it showed annualized volatility of 12.4% versus 18.8% for the S&P 500. So a higher return with lower volatility than a buy-and-hold. Not terrible considering the simplicity of the indicator utilized.

For many, it was just too simple. “You can do better,” they said. “You should have used the slope instead. That is what really works in markets.”

Let’s investigate.

If one had followed the slope of the 200-day to time their exposure to equities, how would they have fared? With a 10.1% return and 12.9% volatility, worse than the moving average itself.

How can that be? Complex is not always better? As it turns out, no. Oftentimes, in life and in markets the simplest solution can be the best solution. I say oftentimes because there is no such thing as always, especially in markets.

That is not to say that using the slope is a bad thing in and of itself, just that there is no magical power to the slope. There will certainly be many periods when using the slope of the moving average will “work” better than the moving average itself. We can see this clearly in looking at the calendar returns of both strategies since 2000.

This year, the simple 200-day moving average has worked better. Last year, the slope worked better as it the year before that. In 2013 they performance exactly the same as neither had a sell signal (the S&P remained above its 200-day moving average with a positive slope for the entire year).

Versus the S&P 500, both performed most strongly in relative terms during periods of large declines, as we saw in 2008 and 2002. Both have lagged the market considerably since 2009. This confirms our conclusion from the paper that moving average strategies are more about downside protection and risk management than outperformance on the upside.

The overarching point here: I have no idea what the “best” technical indicator is when it comes to moving averages. But neither does anyone else because such a thing does not exist. The only thing that does exist is what has done the best in the past, what is deemed to be “working” today. But what has worked in the recent past is not an indication of what will work in the future.

Why?

Because there is a cycle to everything, including technical indicators. The market environment is constantly changing and an indicator that is working well in today’s environment may not work as well in market environment of tomorrow.

If you still love the moving average slope after reading this, great. If instead you want to use the slope of the slope of the slope, wonderful. Who am I to tell you that it won’t work well going forward?

More important than your choice of indicator, though, will be whether you’re willing to stick with that indicator when it inevitably goes through tough times and periods of underperformance relative to buy-and-hold and other indicators. Can you avoid the temptation to abandon your strategy/system or re-optimize to what’s currently “working”? Most can’t/won’t which is why most will fail, even if they have a good strategy on paper that has the ability to do well over long periods of time.