Moving Averages: A Promising Tool in a Volatile Market

These days, stock market watchers are in search of two types of crosses: the death cross and the golden cross. This is Wall Street jargon for indicators in the stock market that suggest its direction, up or down. This type of sign is especially important in a volatile market such as we have now.

Mack Courter writes about the historical effectiveness of this approach in the summer issue of The Journal of Indexes. In his article entitled, “Moving Averages: Are They Effective?” Courter attempts to answer the question by examining 39 years of market data.

He tries to glean whether the longer-term, 200-day moving average crossing above the short-term, 50-day moving average -- the so-called death cross -- indicates a “sell” signal, or a bear market ahead. Conversely, he examines whether the 50-day average crossing above the 200-day average -- known as the golden cross -- signals a “sell,” or impending bull market. (A moving average is the trend of an index or stock over a specified period of time, in this case, 50 and 200 days.)

Courter’s goal is to determine if using these indicators to make trades is as effective as a straightforward “buy-and-hold” strategy.

Using this approach, Courter found that over 39 years, a buy-and-hold strategy yielded an annual return of 6.62 percent, while the dual-cross strategy using the 50-day/200-day moving averages gleaned an annual return of 7.02 percent. (Further, the standard deviation was lower for the buy/sell than the buy-and-hold at 11.81 percent and 17.72 percent, respectively.) Naturally, commission costs would be higher for the buy/sell strategy, as well: The number of trades for the buy/sell strategy was 34, for the buy-and-hold strategy, just two.

In early July, the 200-day moving average in green crossed above the 50-day moving average in red -- this is known as a death cross, which indicates a bear market on the horizon. When the 50-day moving average crosses over the 200-day average on the upswing, it is called a golden cross, or a "buy" signal.

Of course, some investors don’t have the next 39 years to implement this kind of technical trading strategy, and we know that past performance is no guarantee of future results. Nevertheless, Courter points out, if stocks remain as unpredictable as they have been, this method could help some people sleep better at night. Also, invested money would, on average, be preserved when the market falls.

As Coulter points out: “Applying a 50-day or 200-day moving average to the S&P 500 in 2008 would have produced a loss of 3.14 percent and 3.47 percent, respectively. By contrast, a buy-and-hold position in the S&P 500 would have returned a negative 38.49 percent.”

It is easy to assess the moving average of a stock or index by using free charting software on websites such as Yahoo! Finance. To create a chart such as the one above, go to the "Investing" tab, click on "Market Stats" and choose "US" under "Indices" in the left-hand navigation. Choose any of the averages you'd like, such as the S&P500, and then choose a time-frame to chart (say, one year.) Select “Basic Technical Analysis” from the choices to the upper left navigation, and finally click the links for 50-day and 200-day moving average.