A Simple And Timeless Way To Trade The S&P 500 Successfully

| About: SPDR S&P (SPY)
Twenty-five years ago I visited my father in Florida. He had worked on Wall Street during the Great Depression and had been a businessman and active investor for almost 50 years.

He took me into his office and opened a large book of charts. He pointed at a thin red line stretching for decades across one of the charts. He said the red line was a composite moving average of all the mutual funds in America.

"When the market moves above that red line, I buy a couple of all-purpose mutual funds from a list and hold them. When it goes below it, I sell. And I don't get back in until it rises above it again. I've tried many things in this game, but at the end of the day I've never found anything better than this. And remember, there's no such thing as buy and hold for the long term. It doesn't work that way."

Twenty-five years have gone by and his simple advice has outlasted every other strategy I have tried (and I've tried many). Which leads me to that thin red line on his charts, or what I've come to know as the 300 day moving average of the SPX. The American companies that comprise the Standard & Poors 500 (SPX) are a good barometer of our underlying economy. The stock market follows this index religiously, and the red line indicates whether the market is in a bear or a bull mode.

Here's how to grasp the simple logic of the S&P's 300 day moving average. A worldwide army of investors and analysts arise each day to haggle over the value of the S&P's 500 publicly-traded companies. Billions of shares trade back and forth. It's a huge discussion between buyers and sellers. And trading continues throughout the day and into the night via the futures market.

For the next 300 days - 18 consecutive months - trillions of shares will exchange hands as buyers and sellers seek a fair price ($) each day for the companies in the index. It's the average price of those previous 300 days that we seek. As Warren Buffett says, "In the short term the market is a voting machine; in the long term, it's a weighing machine."

Over the course of those 300 days, the direction of the S&P - relative to its long-term average - becomes clear. In a bull market, the SPX 500 will consistently be supported by its 300 day moving average and rise above it. In this scenario you buy - or hold - the dips.

In a bear market, the index will break below the 300 day line dramatically and continue to drop precipitously in the weeks ahead. In the 2000 and 2008 bear markets, this trend change occurred in a single day.

The safest strategy therefore is to be in the market only when the SPX is above its 300 day moving average. Avoiding the catastrophic losses of a bear market is extremely important, because the money you save will be available for the next time a safe buying opportunity arises.

Let's take a look at this methodology for 10 and 15 year returns. Using this strategy, a dollar invested in 1999 would have been $1.79 near the bottom of the financial crisis (March 21, 2009), resulting in a 79% return with a compound growth rate of 6%.

There would have been two exchanges from funds into cash: in September 2000, and January 2008. For three of those ten years (1999-2009), the capital would have sat safely in cash while financial storms raged around it.

If that same dollar had been invested in a buy and hold strategy, the 10 year return would have become a whopping minus (-39%) loss on original capital. The difference between the two methods is a ratio of 3 to 1, or put another way, one investor lost 39% while the other gained 79% from 1999-2009.

Current returns (Nov. 7, 2013) now cover a nearly-15 year span. A dollar invested with this methodology in 1999 would be $3.07 today - a 207% return with a 7.9% CAGR.

There would have been several brief exchanges into cash: June and August, 2010; August, October, and December 2011, and finally once in June, 2012. In the context of a bull market, these dips below the 300 day M/A were event-driven, short-lived, and proved to be buying opportunities.

The buy and hold strategy from 1999 to the present (14.75 years) would have a 40% return and a 2.31% CAGR, but with the profitability coming only in the last 16 months; a very, very long wait.

The difference in total return between the two methods is dramatic, illustrating the importance of timing entries and exits along the 300 day line. The when was as important as the what.

What to buy?

Closed-end index mutual funds (ETFs) offer the best safety and the lowest fees. They are very liquid and trade just like stocks. When you buy one of these funds you are buying the general market, the whole list, and are diversified across all sectors.

80% of all money managers perform in line with a benchmark, usually one of the large indices - like the Dow Industrials, the S&P 500, or the Nasdaq 100. But another 10% under-perform them, so you've actually got only a one-in-ten chance of finding a financial genius who will beat an index-based system in any given year.

Here are some of the index ETF ticker symbols available for trading: SPX 500 (NYSEARCA:SPY), Dow Industrials (NYSEARCA:DIA), Nasdaq 100 (NASDAQ:QQQ).

If you'd like more leverage on the upside, you could choose one of the Proshares Funds: Russell 2000 Small-Caps (NYSEARCA:UWM), Nasdaq 100 (NYSEARCA:QLD), SPX 500 (NYSEARCA:SSO), or Dow Industrials (NYSEARCA:DDM). (Of note, the return for the leveraged SSO is approximately double the return on the SPX 500 used in our methodology.)

The average holding time for a bull market is 34 to 44 months, so you might glance at the S&P's 300 day moving average once a week during that time (if that's too much for you, you shouldn't be doing this in any case).

As the years roll by, as surely as summer moves into autumn, the news media will one day warn you of storm clouds on the horizon. The SPX will suddenly fall below its 300 day moving average. Alarms will sound. The drop will be explained away by talking-heads. The index might rebound briefly (a bear market bounce), but then fall anew.

When that happens, GET OUT, stay out, and wait till the coast is clear.

So often in investing, what you don't do counts for more than what you do. Former Intel CEO Andy Grove once said, "Only the paranoid survive". Preserve your capital. The punishing thrall of a bear market is something to avoid at all costs. Yet when the storm is passed and the coast is clear, it will be time to invest anew. Like springtime, the tide will have turned. There is something of the miraculous in that.

"There is a tide in the affairs of men,
Which, taken at the flood, leads on to all good fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
On such a full sea are we now afloat;
And we must take the current when it serves,
Or lose our ventures."

Brutus, Julius Caesar, Act IV Scene III: From Within the tent of Brutus

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article was first written on March 21, 2009, near the bottom of the financial crisis. It was recently updated to reflect current market conditions.

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