Moving Average Trading System Bucks Bearish Instinct

by: Alligator Investor

I have always been interested in mechanical trading systems and I began to use different systems to trade the markets in the 70s and 80s. Later on, when I had access to a good computer, I back-tested the most promising systems against 50 years of price data for the Dow Jones Industrial Average.

The Dow is ideal for back-testing because it does not trend as smoothly as many things you could trade. If a system works with the Dow, it has to be pretty good! Most of the trading systems I tested showed poor results against this data series. The short-term trading systems fared the worst.

The only system I tested which is good enough to actually use in the stock market is the 50 and 200 day moving average crossover system. The rules are simple: when the 50 day moving average of the DJIA crosses above the 200 day moving average, buy the DJIA at the open the next morning; stay long until the 50 day moving average crosses below the 200, then liquidate the position the following morning.

This is a long-term trading system which gives infrequent signals. It keeps you in the market during protracted rallies but gets you out soon after a serious correction gets under way. And if the correction turns into a multi-year bear market, the system will keep you on the sidelines for the duration.

The 50 and 200 system does not do quite as well as a buy-and-hold strategy, but it does capture most of the upside with a lot less risk.

During the 50 year test period there were several lengthy whipsaw markets which resulted in 3 or 4 unprofitable trades in a row. It would have been hard to stick with the system during one of those difficult periods, but if you had, you would have done quite well in the end.
DIA is the ideal vehicle to use with the 50 and 200 system, but it works well with SPY, QQQQ, and other actively traded ETFs. I have also used it to good effect with mutual funds and even individual stocks.

I don’t give investment advice, and I am not recommending that anyone actually use this trading system; I’m just saying that it works for me.

Using the sell signals to sell short does not work at all! The long-term uptrend of the stock market is just too persistent.

I am more of a buy-and-hold investor than a stock trader now, and I generally use shorter-term technical signals to buy stocks, but the 50 and 200 day moving average system is still handy to provide a daily reality check. Right now, my intuition is telling me that we are on the brink of a bear market, but the 50 and 200 day moving averages are telling me to relax and enjoy the rally as long as it lasts.