Simple momentum investing via the long-term moving average

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by TimeTheRevelator

INTRO

I have been researching a lot of factor investing techniques, and have come to the conclusion that most of the factors investors use are wastes of time. Most signals lose merit when empirically scrutinized, and those that remain do not seem trustworthy over decade-long investment windows.

Except for momentum. For some reason simple momentum investing seems to be the one factor that remains consistent YoY, all for the simple reason that companies and economies that have done well in the past will typically continue to perform well in the future, and vice versa.

X-day moving average (definition): the average closing price of the stock for the past X days. So a 200-day moving average is the average closing price of the fund for the past 200 trading days.

TECHNIQUE

Here’s a simple method for momentum investing I’ve devised (IE: shamelessly copied from people smarter than myself):

  1. Once per month look at the moving average of your favorite major stock market index fund (I use Vanguard’s $VT) using one of the many free stock statistics sites on the web (like BarChart.com).
  2. If the price of the index fund is above its moving average then invest in it. If the price of index fund is below its moving average then move these funds into safe government bonds.

That’s it!

DATA

Momentum trades since 2008 using differing moving averages (MAs) in $VT (Vanguard Total World Stock ETF):

100-day MA 150-day MA 200-day MA 300-day MA 350-day MA
BOUGHT May 09 BOUGHT May 09 BOUGHT June 09 BOUGHT Aug 09 BOUGHT Aug 09
SOLD Feb 10 SOLD June 10 SOLD June 10 SOLD June 10 SOLD June 10
BOUGHT April 10 BOUGHT Aug 10 BOUGHT Aug 10 BOUGHT Aug 10 BOUGHT Aug 10
SOLD June 10 SOLD Sept 10 SOLD Sept 10 SOLD Sept 11 SOLD Sept 11
BOUGHT Aug 10 BOUGHT Oct 10 BOUGHT Oct 10 BOUGHT March 12 BOUGHT March 12
SOLD Aug 11 SOLD Aug 11 SOLD Aug 11 SOLD June 12 SOLD June 12
BOUGHT Jan 12 BOUGHT Feb 12 BOUGHT Feb 12 BOUGHT Aug 12 BOUGHT Sep 12
SOLD June 12 SOLD June 12 SOLD June 12 SOLD Jan 15 SOLD Sept 15
BOUGHT Sept 12 BOUGHT July 12 BOUGHT July 12 BOUGHT March 15 BOUGHT August 16
SOLD July 13 SOLD Feb 14 SOLD Oct 14 SOLD August 15
BOUGHT Aug 13 BOUGHT March 14 BOUGHT Nov 14 BOUGHT August 16
SOLD Feb 14 SOLD Oct 14 SOLD Jan 15
BOUGHT March 14 BOUGHT Dec 14 BOUGHT March 15
SOLD Oct 14 SOLD Jan 15 SOLD Aug 15
BOUGHT Dec 14 BOUGHT March 15 BOUGHT May 16
SOLD Jan 15 SOLD July 15 SOLD April 18
BOUGHT March 15 BOUGHT April 16 BOUGHT May 18
SOLD July 15 SOLD Nov 16 SOLD July 18
BOUGHT Nov 15 BOUGHT Dec 16
SOLD Jan 16 SOLD April 18
BOUGHT April 16 BOUGHT June 18
SOLD Nov 16 SOLD JULY 18
BOUGHT Jan 17
SOLD March 18
Total trades: 24 22 18 11 9
Trades per year: 2.7 2.4 2 1.2 1
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BACKTEST

Here’s how the 300-day MA would have performed against buy and hold for $SPY: dailyreckoning.com/wp-content/blogs.dir/5/files/2012/11/DRUS11-13-12-1.png (source). That’s a 15-year return of 74.3%, almost double the return of simply buying and holding the S&P 500. BUT this return % does not consider taxes (see observation #6 below).

OBSERVATIONS

  1. This technique is wonderful for avoiding massive drops to the stock market while still being invested in the majority of its gains. Imagine being completely in stocks in 2017, but completely out of stocks during the entirety of 2008!
  2. It’s pretty low maintenance. On average, the 200-day MA of $VT trades just 2 times/year!
  3. The longer used MA, the less risk/reward/work. The slower the MA is to respond to trend changes. So you’re talking about less return and lower volatility. Example: when the global stock market tanked in late 2015, the 300-day moving average would have safely moved to bonds in August. In contrast, the 350-day moving average would have waited to sell until September, a month later, meaning an entire extra month of losses vs the 300-day.
  4. The shorter used MA, the more risk/reward/work. For the 100-day moving average of $VT, the number of trades since the 2008 crash balloons to 24, an average of 2.7 per year, with many years having 4 trades per year. And a lot of those trades are whipsawed trades when the market is really moving sideways, making you do a bunch of work that really isn’t necessary, and some of those trades mean moving out of the market when it’s going up, missing out on a bunch of gains.
  5. The data above seems to show the sweet spot is 200 trading days (200-day MA). This seems to be a somewhat decent spot to grab the trend when it changes, but to not get too chopped up when the market spends a season moving sideways.
  6. Taxes are the one factor here which makes this approach earn less money than buy and hold. You’re trading at least once almost every year here, so you’re almost always going to be paying short-term capital gains tax, which is a pretty big hit to your overall return. That said, a few years (2013, 2017) are trade-free, so you have the occasional long term cap gains trade.
  7. Because of tax inefficiency, buy and hold does seem the ideal approach for maximum profit. However, buy and hold does this by leaning on your emotions. In the 2008 stock market crash you would have experienced single digit losses with a 200-day MA approach. Compare this to buy and hold with its 50% drawdown (intra year). Imagine the wonderful feeling of being 100% in government bonds while everybody else is covering themselves in sackcloth and ashes and going through marital stress.
  8. The bond allocation is probably going to be $VGIT, Vanguard’s intermediate term government bond ETF.
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CONCLUSION

I don’t think I’ll use this approach as my main investment, since it doesn’t take advantage of long-term capital gains tax rates, and thus has a lower overall return compared to simply buying and holding. However, I am strongly considering this as a major part of my overall portfolio. Perhaps 40% of my entire stock allocation. So that would be 40% momentum investing via the 200-day MA of $VT, and 60% in my regular buy and hold in index funds. [Note: I’m young and still have many decades of earning potential.]

TL;DR: Momentum investing with major index funds is simple, requiring about 2 trades per year. Once per month (no more! no less!) look at your favorite major index fund. If the 200-day moving average is below the fund’s price, be 100% invested in it. If the 200-day moving average is above the current price, safely move this allocation into 100% bonds. Stick to your rule! In doing so, you will enjoy healthy stock returns while avoiding the majority of market crashes, sleeping better at night during major market turmoil.

 

Disclaimer: Consult your financial professional before making any investment decision.

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