No Empirical Support for the 200-DMA?

This is from the Q&A section of the Fama/French Forum:

Some researchers argue that a market timing strategy based on buy/sell signals generated by a 50- or 200-day moving average offers a more appealing combination of risk and return than a buy-and-hold approach. What is your view?

EFF/KRF: An ancient tale with no empirical support.

That’s simply not true. This is what I wrote about the 200-DMA last year:

One of the quick-and-dirty tools used by technical analysts is to see where a stock or index is compared with its average price over the past 200 days. This is an easy way to get a read of a stock’s momentum.

Yesterday was a big day for the 200DMA world. The S&P 500 closed above its 200DMA for the first time since December 26, 2007. That closed out the index’s longest run below its 200DMA according to my records which go back to 1932.

That streak, however, is still well short of the longest run above the 200DMA which ran from November 1953 all the way to May 1956. Since the index has gone up over time, the “above” streaks tend to be longer than the “below” streaks.

On November 20, 2008, the S&P was a stunning 39.6% below its 200DMA. That’s the biggest discount on my records. The only thing that comes close is the reading from this past March.

So does the 200DMA work? The evidence suggests that it’s a pretty good indicator of future price performance. When the S&P 500 has been below the 200DMA, it’s dropped a total of about 20% over the equivalent of 27 years. In other words, the S&P 500 has been below its 200DMA about one-third of the time.

Historically, the best time to invest has been when the S&P is less than 1.7% below the 200DMA.

When the index is above the 200DMA, well, then everything looks much brighter. All of the market’s gains and then some have happened when we’re above the 200DMA which occurs about two-thirds of the time.

The market seems to like nearly every point of being above the 200DMA. Danger only clicks in when the S&P 500 is over 17.5% above the 200DMA which is a very high reading.

This issue isn’t whether the 200-DMA works or not. It’s a dumb rule, but it reveals an important truth about investing: the market likes trends. If the market is going in one direction, it has a much better than average chance of staying in that direction.

Posted by Eddy on October 11th, 2010 at 1:13 pm

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