Last Updated on May 1, 2021 by Oddmund Groette
Back in 2012 Meb Faber published a paper called A Quantitative Approach To Tactical Asset Allocation in the Journal of Wealth Management. The article looks at the following simple trend following system in the S&P 500:
Go long the S&P 500 when the price crosses the 200-day moving average, and sell when it crosses below the 200-day average. This is probably not the most sensational strategy, to say the least. However, Faber’s article is a great read because of his “simple” ideas, yet very powerful.
This strategy is so simple that it’s easy to dismiss. We have dismissed it many times, and we have not looked at the strategy for about 7-8 years. The temptation to develop more powerful and complex strategies is always lurking in the back of any trader’s head.
The strategy is a so-called trend-following strategy that only looks at the price and nothing else. The strategy doesn’t care about news, earnings, valuations, sentiment, interest rates, and so on. The only focus is what the market is doing, not what it’s supposed to be doing. It can’t get any simpler than that.
One trader legend, Paul Tudor Jones, once said this about the 200-day moving average:
My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.
Trend following the S&P 500 using daily data
Let’s start our test and see how a 200-day moving average performs on the S&P 500:
We buy when the close is above the 200-day moving average, and sell when it crosses below. The logarithmic equity curve above has a max drawdown of 28%, reached in 2002, and the CAGR is 6.73% while buy & hold is 7.16% (the test is not adjusted for dividends).
The simple system sells the S&P 500 in December 2007 and enters again in June 2009, thus the GFC of 2008/09 is mainly avoided. Paul Tudor Jones’ “defense logic” served us very well.
How about Covid-19? It buys on the second of March 2020, sells the next day, goes long again on the 4th, and exits again (!) on the 5th, before it stays on the sidelines until late May. Max drawdown was 19% during this period.
Trend following on the S&P 500 using monthly data
What does the strategy look like if we use monthly data? We go long when the close crosses its ten-month moving average and sells when the close is below the ten-month average. The equity curve looks like this:
100 000 invested in 1960 is worth 5.158 million today, compounded but not including dividends. The biggest drawdown happened during the crash in October 1987 with 26%. The strategy has a CAGR of 6.56% which is slightly lower than the buy & hold at 7.16%.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.