Moving Averages: July Month-End Update

The above table shows the current 10-month simple moving average (SMA) signal for each of the five ETFs featured in The Ivy Portfolio . We've also included a table of 12-month SMAs for the same ETFs for this popular alternative strategy.

For a facinating analysis of the Ivy Portfolio strategy, see this article by Adam Butler, Mike Philbrick and Rodrigo Gordillo:

• Faber's Ivy Portfolio: As Simple as Possible, But No Simpler

Over the past few years we've used Excel to track the performance of various moving-average timing strategies. But now we use the backtesting tools available on the Backtest an Individual ETF

Buying and selling based on a moving average of monthly closes can be an effective strategy for managing the risk of severe loss from major bear markets. In essence, when the monthly close of the index is above the moving average value, you hold the index. When the index closes below, you move to cash. The disadvantage is that it never gets you out at the top or back in at the bottom. Also, it can produce the occasional whipsaw (short-term buy or sell signal), such as we've occasionally experienced over the past year.

Nevertheless, a chart of the S&P 500 monthly closes since 1995 shows that a 10- or 12-month simple moving average (SMA) strategy would have insured participation in most of the upside price movement while dramatically reducing losses.

Here is the 12-month variant:

The 10-month exponential moving average (EMA) is a slight variant on the simple moving average. This version mathematically increases the weighting of newer data in the 10-month sequence. Since 1995 it has produced fewer whipsaws than the equivalent simple moving average, although it was a month slower to signal a sell after these two market tops.

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A look back at the 10- and 12-month moving averages in the Dow during the Crash of 1929 and Great Depression shows the effectiveness of these strategies during those dangerous times.

The Psychology of Momentum Signals

Timing works because of a basic human trait. People imitate successful behavior. When they hear of others making money in the market, they buy in. Eventually the trend reverses. It may be merely the normal expansions and contractions of the business cycle. Sometimes the cause is more dramatic — an asset bubble, a major war, a pandemic, or an unexpected financial shock. When the trend reverses, successful investors sell early. The imitation of success gradually turns the previous buying momentum into selling momentum.

Implementing the Strategy

Our illustrations from the S&P 500 are just that — illustrations. We use the S&P because of the extensive historical data that's readily available. However, followers of a moving average strategy should make buy/sell decisions on the signals for the each specific investment, not a broad index. Even if you're investing in a fund that tracks the S&P 500 (e.g., Vanguard's VFINX or the SPY ETF) the moving average signals for the funds will occasionally differ from the underlying index because of dividend reinvestment. The S&P 500 numbers in our illustrations exclude dividends.

The strategy is most effective in a tax-advantaged account with a low-cost brokerage service. You want the gains for yourself, not your broker or your Uncle Sam.

Note: For anyone who would like to see the 10- and 12-month simple moving averages in the S&P 500 and the equity-versus-cash positions since 1950, here's an Yahoo Finance . Columns D and F shows the positions signaled by the month-end close for the two SMA strategies.

Written By: Doug Short