Moving Average: Holy Grail or Fairy Tale – Part 3

Originally Published July 28, 2009 in Advisor Perspectives

“If there was ever a good time to consider a new investment approach,” an advertisement for a mutual fund company proclaimed in a recent issue of a financial planning magazine, “it’s when the old ones have proven so fallible.” For a second, I thought that they had finally given up on the tired buy-and-hold (B/H) approach. It turned out they were just promoting a new kind of index fund.

Buy-and-hold remains deeply entrenched in the financial planning community, despite many of the flaws my previous articles have illustrated. Although many financial advisors suffer dearly from their B/H practices, they are reluctant to change their approach. Who dares to challenge investment sages like Bogle, Siegel, and Malkiel who emphatically support this long-standing investment principle? Academic research studies overwhelmingly endorse B/H. How can they all be wrong?

Perhaps the investment scholars and researchers are right to advocate B/H, but for the wrong reason, as I will explain later. But first, let me digress to respond to some of the feedback my previous articles received.

Let’s be clear

I am gratified to learn that many readers are able to replicate my results. My research is only credible if it passes peer reviews. A couple of readers, however, had difficulty reproducing my exact numbers. I use Professor Robert Shiller’s S&P500 Index primarily because his data is accessible to the public, so that my calculations can be checked. But Professor Shiller creates his monthly index by averaging daily closing prices. If you use actual daily or monthly closing prices, you will get different results.

Several analysts also inquired about the actual implementation of the Moving Average Crossover (MAC) system. For the record, it is not my intention to promote the MAC system as a trading tool. There are many trading systems used by active managers with proven track records. I use MAC as a demonstration to challenge the popular notion that no one can beat the markets in the long run. In science, it only takes one counterexample to invalidate a principle, no matter how well-established it might be.

Establishing a way to implement active investment management systems into a business practice exceeds the scope of my articles. For those planners new to the field of rule-based trading systems, my advice is to work with a reputable active investment firm or to use experienced consultants. It’s not a do-it-yourself project.

Let’s revisit market history

Implementation considerations aside, let’s turn to a more detailed analysis of the MAC system, and see how it compared to B/H pre- and post- the Great Depression, as well as during each of the last 14 decades.




The effectiveness of the 6-month MAC system is illustrated graphically in Figure 1. I present the 138-year history into two plots of seventy years each for better visual clarity. All the buy and sell signals are superimposed on the S&P500 Index in two colors. The red segments (sell) depict periods when the Index was below its 6-month moving average; and the green (buy), above. The blue curve shows equity accumulation from three contributing factors: capital gains resulting from MAC transactions, reinvestment of dividends while in the markets, and capital preservation in cash while out of the markets. A $1 investment in 1871 would have soared to $332,000 in June 2009. By comparison, $1 invested under the B/H approach with dividends reinvested earned only $105,000 over the same period. Note that without reinvesting dividends a $1 investment in the S&P500 Index itself only returns $211 (from $4.44 in 1871 to $938 in June 2009).

A tale of two periods




As we have seen, the 1929 crash gives MAC an advantage over B/H as seen in Figure 1. Several readers wanted to know how MAC would have fared if we removed the one- time impact of the Great Depression. In Figure 2, I show two separate investments with $1 each at the beginning of the two seventy-year periods. From 1871 to 1940, the B/H strategy returned 100-fold and MAC beat it by a factor of five, primarily a result of side- stepping the Great Depression. From 1941 to June 2009, without the impact of the Great Depression, both systems gain 1,000-fold and tie at the end. However, B/H outperforms MAC for most of the seven decades. So you may say that B/H is indeed unbeatable, if bear markets like the Great Depression, the Oil Embargo of 1974, the 2000 Internet Bubble, and the 2008 Sub-prime Meltdown can all be ignored. B/H can be considered as a bull market Holy Grail.

Dissecting the decades 

Let’s examine market history in a different light. In Part 2, I compared MAC’s monthly and annual performance to that of B/H. MAC beat B/H on both counts. But by looking at monthly and even yearly perfromance you could miss the forest for the trees. Examining decadal performance, thought, one gains new insight from a longer-term perspective.




Figure 3 shows Compound Annual Growth Rate (CAGR) by decade. The 138 years cover fourteen decades. The upper graph compares B/H to MAC. The lower graph is more instructive, as it shows the net CAGRs (MAC minus B/H). Out of fourteen decades, B/H outperforms MAC in only six, and by small margins. Five of those six decades occurred after 1941. In those decades when MAC outperforms B/H, the margins are quite significant. Finally, for more than a century, the current decade is the only one that B/H has shown a loss, although the current decade is not over yet.

The Emperor has no clothes! 

I mentioned earlier that researchers are right to endorse B/H, but they do so for the wrong reason. They are right that B/H has an impeccable track record over six decades. But they are wrong to declare B/H as the best way to invest at all times. B/H underperfomed more than half of the time in 138 years. They are also wrong when they justify their argument with theories such as the Modern Portfolio Theory and the Efficient Market Hypothesis. The markets were quite efficient during all bear markets so why didn’t B/H work then? History and simple logic tell us why B/H didn’t work in many decades before the ’40s, why it has worked for so long after the ’40s, and why it has stopped working since 2000. You don’t need advanced economic theories to explain the obvious.

After World War II, the West, led by the United States, unleashed the power of the free market system. Capitalism fueled technological innovation, which in turn bolstered global economic expansion. As a result, the stock markets enjoyed the most powerful and the longest advance in human history. The unprecedented secular bull markets skyrocketed 1,000-fold and lasted six decades. All academic research sudies focused on this post-WWII era naturally concluded that no one can beat the markets. The efficient market theories had little to do with B/H’s success. The B/H strategy was the Holy Grail simply because of the secular bull markets.

Then came 2000. The markets tumbled and B/H faltered. Researchers who clung to six decades of flawless records with a seemingly sound theoretical underpinning were perplexed. Since bull markets always returned in the past, they waited, only to get hit again in 2008. They continue to hold, wait, and hope.

As an engineer surrounded by financial scholars and investment geniuses, I feel like the little boy watching the naked Emperor in the parade. I point out the obvious with no fear of embarrassing myself. President Clinton once said, “It’s the economy, stupid!” I holler, “It’s the bull markets, Professors!” The truth is that B/H works wonders during economic expansions, but it underperforms during economic slowdowns or contractions. If there were no bear markets, B/H would indeed be the Holy Grail!

Diversification in time

The Modern Portfolio Theory tells us not to put all your eggs in one basket. The B/H strategy calls for holding all your eggs in one continuous “basket” of time. That sounds like a risky proposition to me. Market timing is not witchcraft. It reduces risk through temporal diversification. There are times to hold, and there are times to fold.

Active investment management with market timing works not by forecasting the future, but by following major market trends. By way of example, let me illustrate how the 6- month MAC system described in Part 1 and Part 2 realizes temporal diversification. Figure 4 shows the difference between $1 investments in B/H and in MAC made in

January 2000. How have the two systems performed through the 2000 Internet Bubble and the 2008 Systemic Meltdown, to June 2009? I’ll let you be the judge. The MAC system doesn’t predict the markets, it follows the trends. It doesn’t sell at peaks or buy




at bottoms. But it’s effective in preserving wealth in bear markets and accumulating wealth in good times.

Now you know why the B/H strategy that worked so well in the past has proven so fallible since 2000. The question is whether you believe the secular bull of the past is likely to return after the current recession is over. If you think that the next decades will not match the good fortune of the post-WWII era, you should start looking for an alternative investment approach.


UPDATE: Read the original Advisor Perspectives replies to this article.



What the “Missing Out” Argument Misses

Originally Published May 26, 2009 in Advisor Perspectives

Market timing is discredited by passive investment advisors as a voodoo ritual. Buy-and-hold proponents argue most compellingly by citing the “missing out” scenario - they show a dramatic drop in return, to Treasury Bill levels, if investors are out of the markets for only a few good days. Missing these market surges is considered a risk of lost opportunity.

However, they conveniently ignore the risk of being hit by devastating market crashes and the associated emotional stress of staying in the market at all times. I quantify this anxiety level by calculating the historical stock market drawdown for the past 137 years, since Ulysses Grant was President. You decide if staying the course justifies the pain and suffering. If you could avoid the nastiest crashes at the expense of missing a few spectacular rallies, how would your return fare against that of buying-and-holding?

Most of the “missing out” calculations show missing only the best days. Those analyses cover only a decade or two. I examined monthly data as far back as 1871 and daily data from1942 to present. I used the S&P500 total return index with dividend reinvestment. I considered three scenarios, namely, excluding the best surges, removing the worst plunges, and eliminating both the best and the worst extremes. To compare those three scenarios to the buy-and-hold benchmark, I calculated their CAGR (Compound Annual Growth Rate), sometimes referred to as the geometric average annual return.

Figure 1 shows the CAGRs for the different “missing out” scenarios based on monthly data. Excluding the best twenty-four months would reduce the return from 8.6 percent (the buy-and-hold benchmark) to 6.4 percent. What most passive managers don’t report is that by avoiding the worst twenty-four months, you could boost return to 11.5 percent.

Figure 2 presents CAGRs based on daily data. Excluding the best fifty days lowers the return from 10.0 percent (the buy-and-hold benchmark) to 6.1 percent; but eliminating the worst fifty days increases performance to a remarkable 15.2 percent.




The returns of missing both the best and the worst months are better than the returns from the buy-and-hold strategy as shown in Figure 3. Missing both extremes beats buy- and-hold across the board as shown in Figure 4. Who would mind getting similar returns to buy-and-hold without the volatile extremes? Isn’t volatility considered risk?

The seemingly compelling “missing out” argument cited by buy-and-hold advocates falls apart under cross-examination.
Passive investment advisors commonly advise their clients that the longer investments are held, the greater the chance for attaining positive returns. The upward bias of the stock market favors buy-and-holders. To determine the breakeven holding period, I calculated the equity drawdown of the S&P500 index. Drawdown is the percentage decline from the most recent equity peak. It represents the emotional pain investors have to endure while holding stocks of lost values.
The black curve in Figure 5 illustrates how often, how long, and how severe the S&P500 index suffers from drawdown, measured over the last 137 years. Let us examine the plot closely. First, drawdowns occur more often than one might think. Equity is underwater ninety-two percent of the time during this period. The roaring1990s is the exception rather than the rule. Drawdown consumes over fifty percent of this most bullish decade. Second, many drawdowns last a long time. The 1929 crash took twenty- six years before it finally broke even in 1955.
Third, since equity investments are considered an inflation hedge, we must consider inflation when discussing drawdown. The purple curve shown in Figure 5 is the drawdown adjusted for inflation, as measured by the Consumer Price Index. Although the nominal S&P500 index made new highs briefly in 2007, the real S&P500 was fifteen percent below its 2000 peak at the time. Inflation adjusted drawdowns are steeper and longer than nominal drawdowns.
Drawdowns with devastating magnitudes are quite common. The market suffers losses in excess of forty percent more than a third of the time. Only a man of steel can withstand the frequent, prolonged, and torturous emotional trauma inflicted by staying fully invested at all times.

“No one purchases just one index. We diversify...” argue buy-and-hold enthusiasts. By constructing a portfolio of uncorrelated stocks, you can dampen the impact of the specific risk of each stock. But correlations among different asset classes change with time, depending on the market environment. Two previously uncorrelated stocks can suddenly move in unison and render diversification ineffective.
More importantly, diversification cannot dodge the systematic risk of the entire market. During bear markets, most stocks decline together. When systematic risk is exacerbated by the systemic risk associated with the catastrophic collapse of global financial institutions, not only do the equity markets take a blood bath, but most other assets follow. In 2008, all asset classes plummeted, including US equities (all styles, sizes, and sectors), emerging markets, bonds, real estates, commodities, and currencies. The only uncorrelated asset during a systemic crisis is cash. The prudent way to reduce risk is to rebalance your portfolio with cash equivalents. Isn’t that called market timing?
Buy-and-hold proponents may cling to the belief that market timing is futile, since no one knows the future. Who said that market timers must foretell the future? Active asset allocation practitioners like Brian Schreiner and Mebane Faber are trend followers. As mentioned in their recent articles, a ten-month moving average system would have avoided both the 2000 crash and the 2008 meltdown. Is the moving average system a sound investment methodology or just a myth? I will explore this topic in a future article.

Ask yourself this question, “If you could help your clients avoid most the bear markets, would they mind missing a few mighty rallies?” Human beings are more sensitive to the pain of losing than to the joy of gaining. That’s why most passive financial advisors don’t buy the “missing out” argument, especially during bear markets. You may not be ready to sign up for lifetime membership to The Market Timers Association, but if you are losing faith in buy-and-hold or are losing clients, you are not alone among mainstream passive managers. Data –
All data are total return series.
S&P500 Monthly Series – Provided by Robert Shiller of Yale University.
S&P500 Daily Series – Provided by Ultra Financial Systems, LLC.


UPDATE: Read the original replies to this article