Trend Following Vs. Market Timing

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Includes: BXUB, BXUC, CAPX, DHVW, EPS, FTA, IVE, IVV, IVW, PPLC, RPG, RPV, RSP, RYARX, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPVU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SPYG, SPYV, SSO, TALL, UPRO, VFINX, VOO, VOOG, VOOV
by: Walter Zelezniak Jr

Summary

My moving average crossover system provides decent results for managing my retirement assets.

I am looking for a way to reduce the time lag of my system for entering and exiting the markets.

The Price Percentage Oscillator indicator is discussed as a way to reduce the time lag.

Readers who follow my monthly series on how I manage my retirement assets know that I use a moving average crossover system to identify buy and sell signals. Here is a link to my most recent article in that series. It is a very simple system that uses the 6 month and the 10 month exponential moving averages. When the 6 month moving average crosses above the 10 month moving average that indicates a buy signal. That buy signal shows that the moving average pair is in bullish alignment. Conversely, when the 6 month moving average crosses below the 10 month moving average that indicates a sell signal otherwise known as a bearish alignment. I like this system because it is simple and generally speaking has put an investor on the right side of the market for major market moves. It is a trend following approach to entering and exiting the market. See Chart 1 below.

Chart 1 - SP 500 Monthly and the 6/10 Moving Average Pair

As Chart 1 shows an investor that followed this simple system would have gotten out close to the top in late 2000 and close to the top in early 2008. That same investor would have been able to enter the market in late 2003 and in late 2009. For an investor who wants to be on the correct side of major market moves this system works well.

One drawback to this moving average pair is that the investor receives a buy signal months after the actual bottom of the market. See Charts 2 and 3 below.

Chart 2 - SP 500 Monthly and the 6/10 Moving Average Pair, 2002 - 2003

Chart 3 - SP 500 Monthly and the 6/10 Moving Average Pair, 2008 - 2009

Moving averages always lag price and the answer to that is to simply shorten the moving average period but that also comes with a drawback. That drawback is the false signal also known as the whipsaw. Consequently, I am interested in shortening the lag time of my moving average crossover system without changing the moving average pair. Obviously, before my moving average pair crosses into a bullish alignment the spread or the difference between my moving average pair has to narrow. Once this narrowing occurs, that may offer an opportunity to at least scale into or scale out of a position in the hope of entering closer to the bottom of the market or exiting closer to the top of the market respectively. It is this narrowing between the two moving averages that I am interested in quantifying. If I can determine that the difference between the two moving averages is narrowing maybe that can be a time to take action.

An indicator to assist in this effort is the Price Percentage Oscillator (PPO). According to stockcharts.com the PPO "is a momentum oscillator that measures the difference between two moving averages as a percentage of the larger moving average." Its default setting is 12,26,9. For the default setting the PPO provides two lines. The first line is the 12 period moving average minus the 26 period moving average divided by the 26 period moving average all times 100 since it is percentage oscillator. The second line is called the signal line and it is a 9 period moving average of the first line. There are multiple ways to use the indicator and it is very similar to the Moving Average Convergence Divergence or MACD indicator. What intrigues me about the PPO is that if I adjust the default setting to 6,10,1 and use it on a monthly chart I will get only one line that measures the difference between my two monthly moving averages, the 6 month and the 10 month. The 1 in the 6,10,1 setting provides a 1 period average of the 6 and 10 month moving averages. In other words I can see on a chart the mathematical difference between my moving average pair as represented by one line. See Charts 4 - 7 below. The charts cover the market top of 2000, the market bottom of 2003, the market top of 2008, and the market bottom of 2009.

When the PPO line is below the zero line it indicates the moving average pair is in bearish alignment. When the line turns up from below the zero line it indicates that the difference between the moving average pair is narrowing or getting closer to a bullish crossover. The slope of the line can be seen on the chart. When the slope of the PPO line is rising from below the zero mark, this represents the signal to scale into the market. When the PPO line is above the zero mark it indicates that the moving average pair is in bullish alignment. When the slope of the PPO line starts to decline it indicates an opportunity to scale out of the market.

Chart 4 - SP 500 Monthly and the 6/10 Moving Average Pair, 1999 - 2002 w/ PPO

Chart 5 - SP 500 Monthly and the 6/10 Moving Average Pair, 2001 - 2004 w/ PPO

Chart 6 - SP 500 Monthly and the 6/10 Moving Average Pair, 2007 - 2009 w/PPO

Chart 7 - SP 500 Monthly and the 6/10 Moving Average Pair, 2008 - 2010 w/PPO

The differences between the two buy and sell signals are summarized in Table 1. The PPO signal improved my entry point in both market bottoms. It improved my exit point at the 2008 market top, but it did not improve my market exit in 2000.

Table 1 - Moving Average and PPO Market Signal Summary

Month of market bottom

Month of crossover buy signal given

Entry Month

SP 500 Entry Price

Month of PPO buy signal given

Entry Month

SP 500 Entry Price w/ PPO

Price Difference

Oct 2002

July 2003

Aug 2003

990.31

Nov 2002

Dec 2002

936.31

54.0

Mar 2009

Oct 2009

Nov 2009

1036.18

Apr 2009

May 2009

872.74

163.44

Month of market top

Month of sell signal given

Exit Month

SP 500 Exit Price

Month of PPO sell signal given

Exit Month

SP 500 Exit Price w/ PPO

Price Difference

Mar 2000

Nov 2000

Dec 2000

1319.71

Aug 1999

Sep 1999

1321.12

-1.41

Oct 2007

Feb 2008

Mar 2008

1330.45

Aug 2007

Sep 2007

1473.96

143.51

In all fairness, the PPO signal did also provide false signals and those are identified in the charts. The technique may be more useful simply for identifying market bottoms. I say that because markets can rise an infinite amount but they can only fall to zero and it is unlikely that will happen to major market indices. Consequently it may be worth the risk to try to scale into the markets on a PPO buy signal. If the PPO signal rolls over a market participant can simply exit their position with hopefully just a small loss. Future articles in my series of investing my retirement assets will further explore the PPO indicator and perhaps I will be able to identify places where I can scale out or, more likely, scale into the market in order to try to improve my investment results.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.