Trend following the S&P 500 is probably not the sexiest thing to do. Back in 2012 Meb Faber published a paper called A Quantitative Approach To Tactical Asset Allocation in the Journal of Wealth Management. Meb Faber found the 200-day moving average useful and decided to look at the following simple trend following system in the S&P 500 based on the 200-day moving average:
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.
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Why is the 200-day moving average useful?
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 (a simple algorithm).
First, the principle of using a simple moving average as a trend filter is extremely easy and simple. Meb Faber’s 200-day moving average strategy is so simple anyone can grasp the idea after 5 seconds, even non-traders and investors.
One trader legend, Paul Tudor Jones, once said this about the 200-day moving average in an interview with the author Michel Covel:
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.
It turns out that Paul Tudor Jones is right about the 200-day moving average. It keeps you out of trouble and avoids many nasty drawdowns. We assume that Paul Tudor Jones trading strategy is a bit more sophisticated than just this filter, but it shows that even the simplest things can contribute. However, Paul Tudor Jones is no particular fan of trend following as he believes markets most of the time don’t trend.
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But the question is: does this trading system also mean you forego profits – in the long run?
Let’s test and find 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:
The trading rules are simple: 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). S&P 500 trends little in the short term, but in the long term, it trends upward.
The simple S&P 500 strategy 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 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%.
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Conclusion about trend-following the S&P 500
Both Meb Faber and Paul Tudor Jones find the 200-day moving average useful and so should you. It’s not the best indicator, but the 200-day moving average is an extremely simple tool to keep you on the sidelines when the storm hits. It’s a simple trend system, but it works reasonably well.
Even better, you manage to keep up reasonably well with the overall long-term returns in the stock market by using the 200-day average. Trend-following the S&P 500 works.