Moving Away from Moving Averages

Attempts to time the market by gauging moving-average momentum can be a danger to your financial health

Many technical strategists monitor the S&P 500's 17-week moving average of prices in relation to its 43-week moving average, believing they indicate a bullish trend when the 17 is above the 43, and a bearish trend when the nearer-term moving average is below the longer-term average.

Being a natural skeptic (but willing to leverage something if it works), I decided to see if this indeed was true, and whether it could also be used to help spot trend changes -- and create a market-timing technique -- for the S&P 500 and its sectors.

First, a word about moving averages, which are statistical tools used to determine the momentum of a stock, bond, fund, or index. A simple moving average is calculated by adding up all the price data for a specific period of time and then dividing the sum by the periods used. Moving-average levels that are above the price of the security are considered bearish, while those below the current price are bullish.


  I first computed the monthly price performances for the S&P 500 and its sectors over the past 10-plus years (S&P came out with sector-level indexes in December, 1994). I then calculated the 10-year compound annual growth rates for the market and its sectors using this timing technique by buying each index during bullish trends and selling during bearish trends. I also compared these returns with those for straight "buy and hold" approaches during the same 10-year period.

Did this timing technique add value? Not in our opinion.

The performance of the overall S&P 500 index was helped by using this timing technique -- it had a 9.0% CAGR using the timing technique, vs. a 7.8% CAGR untimed, mainly because it got you out of the Information Technology & Telecommunications sectors early in the market meltdown of 2000-02.


 But the timing technique actually hindered the performances of seven of the 10 sectors in the S&P 500. In fact, it cut in half the performances for the Energy, Industrials, and Financials sectors, and forced the Consumer Discretionary and Materials sectors into negative territory. Needless to say, it also increased the trading activity, which would have further affected actual returns due to higher transaction costs.

So if you're thinking of timing S&P 500 sectors with short- and longer-term moving averages, be careful. You might be disappointed. As with any back-tested technique, remember that past performance is no guarantee of future results.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of March 17, 2006.

Before it's here, it's on the Bloomberg Terminal.