Exponentially Curb Your Enthusiasm

Investors and the financial media have been excited of late about the S&P 500 crossing above its 200-day moving average:

Harris Private Bank and Morgan Asset Management say the advance may indicate the bear market in U.S. equities that began in October 2007 is over, heralding more gains after a three- month, 39 percent increase. Analysts who base forecasts on price charts consider crossing above a moving average bullish because it shows stocks are rising faster than the long-term trend.

“That’s proven to be a fantastic signal,” said Jack Ablin, chief investment officer at Chicago-based Harris, which oversees $60 billion. “A lot of investors will view it as a bullish signal and will likely use that as a rationale to add exposure to the S&P 500.” [Bloomberg]

As I’ve discussed before (”Moving Averages and Human Risk“), plain vanilla moving average signals aren’t really that special: anything that keeps us from being long the market during its most volatile periods is likely to improve risk-adjusted returns, but we also want signals that have a genuine performance-boosting edge. Neither a 200-day simple moving average nor the exponential variation I’ll address below outperform enough to warrant consideration as independent indicators. But the exponential calculation certainly seems preferable, and suggests that, for the moment, investors would be better served to remain cautious.

The three backtested equity curves below display 1) a buy-and-hold portfolio tracking the S&P 500 (blue), 2) a long-only portfolio using the 200-day simple moving average (SMA) as a timing signal (red), and 3) a long-only portfolio using the 200-day exponential moving average (EMA) as a timing signal (orange).* Transaction costs are not included, nor are returns on cash, and returns are logarithmically scaled.

The portfolio using an EMA timing signal is about 16% higher at the moment than the portfolio following the SMA. The rather intuitive advantage provided by an exponential moving average is that it is more responsive to new information. When prices begin rising in the midst of a downtrend, the EMA rises in response more quickly than its simpler cousin; conversely, a selloff amidst a bullish trend will push the average lower more quickly. In both cases, “false positives” are less likely: the emphasis applied to more recent prices forces the market to work harder to prove a trend reversal.

That’s the big picture. How does it apply to the current situation? As the chart above shows, the break above the 200-day SMA (red line) that occurred in the last hour of trading on June 1 did not close above the 200-day EMA (yellow line). The index closed a few cents above its EMA the following day in SPX and SPY, though not in the Emini S&P futures. It is now caught between the two, above the simple but below the exponential average, meaning that investors using the latter as a timing signal are not yet willing to break out the Dow 10,000 hats and champagne.

* The multiplier used in calculating the EMA for this study was 2/(period+1).

Comments

[squark62:]

i agree with your premise & conclusion. generally what you posit is correct. the only thing i can think of at the moment to discount your rational position is that very few people are in control of the market right now. so we're in a golden rule - who has the gold makes the rules - kind of market. these few institutions are sitting a pile of cash given by uncle sam to boost the economy. i'm inclined to be pessimistic and say that instead of making money by using the funds to lend, they are controlling the market to make their gains. who has more many to stop them from doing so? hedge funds? sovereign equity? these institutions know exactly what they are doing.

Jun 05 10:29 AM

[JohnnyJunk:]

I'm surprised by the results of the back testing. I would think that using the SMA would have you catch more of bull market and less of a bear. False positives would definitely be higher and so would transaction costs as a result, but your results don't attempt to include that aspect.

Jun 05 11:45 AM

[mb2:]

Another "ramp job" on the close today? or, the "elevator" down?

Jun 05 12:01 PM

[Tomcat101:]

We broke above the 200 day SMA during the last bear market a time or two also before we actually hit the true bottom. I don't think this thing is over yet. We really have a mess on our hands.

If things start looking up, the fragile consumer is going to get bitch slapped with high mortgage rates and $4-5 gas and then we are right back where we started.

Jun 06 12:09 AM

[untrusting ...:]

Exactly right. That is precisely why investors need to be EXTREMELY cautious about this market. And it is probably why many large players such as hedge funds, pension funds are also highly reluctant to commit much to this market.


On Jun 05 10:29 AM squark62 wrote:

> i agree with your premise & conclusion. generally what you posit
> is correct. the only thing i can think of at the moment to discount
> your rational position is that very few people are in control of
> the market right now. so we're in a golden rule - who has the gold
> makes the rules - kind of market. these few institutions are sitting
> a pile of cash given by uncle sam to boost the economy. i'm inclined
> to be pessimistic and say that instead of making money by using the
> funds to lend, they are controlling the market to make their gains.
> who has more many to stop them from doing so? hedge funds? sovereign
> equity? these institutions know exactly what they are doing.

Jun 06 12:21 AM

[H. T. Love:]

I like you thesis. But when "extraordinary forces" may be in play, we have to be especially suspect of technical indicators. The best summation of what I think may be going on is detailed in this seekingalpha.com/artic...
from J.S. Kim.

HardToLove

Jun 06 11:21 AM

[Alphameister:]

Both versions of the 200-day moving average are still in decline. A new bull market won't be confirmed until the averages are able to establish a pattern of higher highs and higher lows above a rising 200-day average. The current upward penetration is a necessary but not sufficient development to herald a bull market.

Jun 06 02:47 PM

[squark62:]

kim is basically right in the article you referred to in my opinion. it will also be more clear what the big banks are going when they report Q1 earnings. it's very likely they will have very weak top-side earnings derived from normal banking operations. be skeptical of a rosy outlook picture (if they give any at all) which will be in stark contrast to normal measures of economic growth.


On Jun 06 11:21 AM HardToLove wrote:

> I like you thesis. But when "extraordinary forces" may be in play,
> we have to be especially suspect of technical indicators. The best
> summation of what I think may be going on is detailed in this seekingalpha.com/artic...
>
> from J.S. Kim.
>
> HardToLove

Jun 06 03:57 PM