The 200-day moving average did it again, raising serious questions about whether anyone should still pay attention to it.
This popular U.S. stock market indicator flashed a “sell” signal on the precise day of the market’s post-Brexit-vote low (see chart above). The 200-day moving average is used by many trend followers as a confirmation of a major bear market, but in this case the market’s decline was over right when the moving average urged investors to get out.
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Of course, if this were the 200-day moving average’s only misstep, followers should be willing to forgive it. But it isn’t. Recent experience has been more the rule than the exception for many years now.
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Consider the period dating back to the turn of the century. Since then, the S&P 500
has performed better following sell signals, on average, than it did the rest of the time, as the chart below shows.
That is a damning indictment: Traders would have beaten the market not just by ignoring its sell signals, but actually treating them as buy signals.
To be sure, the 200-day moving average had a better success rate during the 20th century than it does so far in the 21st. So those of you with generous dispositions might still be willing to give it the benefit of the doubt.
But, as I argued in a column last May, the apparently good track from the 20th century is at least partially the result of biased research. That column quoted Vincent Deluard, an investment strategist at Ned Davis Research, who found that, after correcting for those biases, the 200-day moving average’s reliability in those earlier decades greatly diminishes.
Even if you don’t discount the 200-day moving average’s record during the 20th century, there’s also a theoretical reason to question it going forward. Blake LeBaron, a Brandeis University finance professor, has found in his research that moving averages of various lengths stopped working in the 1990s not only in the stock market, but also in the foreign-exchange markets.
Those two markets are not linked in any obvious way that could explain why moving averages would fail simultaneously in both. Accordingly, LeBaron’s work supports the notion that something fundamental has changed in the markets.
What might that fundamental change be?
No one knows for sure. But LeBaron suspects that one big change is the advent of cheap online trading, especially the creation of exchange traded funds, that makes it far easier to trade in and out of securities according to the moving average. Decades ago, in contrast, someone wanting to get out of the S&P 500 would have had to sell 500 individual stocks at exorbitant commission rates.
Another factor, LeBaron has told me, could be the moving average’s popularity. As more investors begin to follow a system, its potential to beat the market begins to evaporate.
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The bottom line? Don’t look to the 200-day moving average for guidance on when we will be in the next bear market.
For more information, including descriptions of the Hulbert Sentiment Indices, go to www.hulbertratings.comor email [email protected]