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If you're actively managing your portfolio, you're acutely aware of the need for risk management. Part of that risk management involves developing investment rules and strategies to help guide you through the market minefield - all the more critical if your objective is to beat benchmarks through stock picking.
Here's an easy example: General Electric (NYSE:GE). It seemed like a no-brainer investment back in September of 2007 with the stock trading around $40 and nothing but blue skies ahead for one of the world's great companies, the builder of jet engines with an unassailable AAA credit rating. Jump cut to January 2019 with the stock at $8 and change. Investors who stuck with the company saw a return of -8.0% annually for each of the past 12 years (that's a -8.0% CAGR - compound annual growth rate). That'll suck the life out of some good stock picks and help flatten an otherwise respectable portfolio. Get into the weeds with GE at Bloomberg's "How GE Went From American Icon To Astonishing Mess."
While most serious investors are open to tips and techniques that could help them avoid such slow-motion train wrecks, the marketplace of risk management is a morass of often conflicting advice.
To help separate wheat from the chaff, the best managers use some combination of both fundamentals and technicals to drive action. In this article, we're going to look behind the curtain at one risk management strategy widely lauded by technical traders: buying and selling stocks (or ETFs) based on moving average indicators. More specifically, based on the periodic intersection of two popular and widely-followed simple moving averages (SMAs).
Traders and the financial commentariat frequently refer to "crosses" made when two moving averages intersect on a chart. Most notably, crosses between the 50-day and the 200-day moving averages.
When the 50-day moving average rises above the 200-day moving average, it's called a "golden cross" and is considered a bullish sign. When the 50-day moving average crosses below the 200-day moving average, it's called a "death cross" and considered a bearish sign. See Figure 3 for an example of the latter (day-of-cross trading) for IBM (NYSE:IBM).
Traders are known to stalk charts waiting for a cross of these two SMAs and trade accordingly. But do the results actually support this strategy?
Let's punch the numbers
In Figure 4, I've compiled a list of ten individual stocks and three ETFs tracking key market indices. The stocks were selected off the top of my head (meaning, without an agenda), and I give no assurance that this is a representative sample of U.S. companies. Although looking at them a second time, they do tend to demonstrate some semblance of marketplace diversity.
Table details: The test period is 17 years, (2000-2017 unless otherwise noted), and the numbers represent total returns. When out of the security in question, we're in a Vanguard money market fund, a proxy for cash. And finally, we're executing end-of-month trading (as opposed to trading on the day of cross).
Remember, we're comparing buy-and-hold investing vs. a strategy of trading the security based on the position of its 50-day SMA relative to its 200-day SMA (buying when the 50-day is above, and selling when the 50-day is below).
OK, there were a few successes among these examples. But take a look at IBM, the subject of our "death cross" example in Figure 3. Playing this strategy, you not only would have missed a 93.7% gain at the end of 17 years (modest by any measure) but you would have actually lost money.
So, why end-of-month trading? Why not trade on the day of intersection for the two moving averages? The latter actually proved worse for long-term returns.
Well, that was a bust
As it turns out, playing the crosses is pretty much a gamble. No telling whether your stock or fund will come out in the green or the red until a sufficient period of time has passed. And given a sufficient period of time, we're all dead.
What went wrong? If I had to hazard a guess, I would say that the strategy of trading the crosses fails to predictably and consistently beat buy-and-hold because of the sheer number of head fakes and false signals in the marketplace, times when a security or fund appears to be moving in one direction only to end up reversing course and moving in the other.
This is especially true for individual stocks; they move to the beat of their own drums in addition to taking marching orders from the overall market. Less true for funds mirroring the broader market. In fact, the broader the index and the larger the cap rate of stocks that make up that index, the fewer the false signals. Hence, the more consistent the outperformance when applying this strategy to SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and Invesco QQQ ETF (NASDAQ:QQQ).
In addition, the days of largest gains (and losses) for individual stocks tend to cluster. Miss a few days of above-average gains, and you lose out on the compounding effect (generating earnings from previous earnings) of those gains for years to come. The SMA strategy we've outlined does not appear particularly good at capturing those gains.
A silver lining
Can we wrench any good out of this?
Trend indicators are not, in general, return enhancing. They can be, but where they often shine is in their ability to reduce volatility and drawdown. They are primarily protective measures. And in that sense, moving averages and their crosses may have a role to play. As detailed in Proactive Advisor Magazine:
"The value of exiting at the death cross is the reduction of portfolio destruction. There is only one time (from 1960 to 2015) when the drawdown was deeper than 20% using a death cross 'exit plan.' But, the buy-and-hold investor has had to endure nine major drawdown events below -20% before markets climbed up to make another new high-with five of those events below -30%, two below -40%, and one below -50%. No one wants to tolerate that kind of pain. Therefore, paying attention to golden-cross and death-cross macro events should be considered 'bypass deep drawdown insurance.' The cost of insurance is the latency of entering after the golden cross."
- Ian Naismith, Understanding The Impact of the Dreaded Death Cross, Proactive Advisor Magazine, September 2018
So, why has this article been focused primarily on enhancing returns? Don't I care about portfolio destruction? Actually, I care deeply about portfolio destruction. But I kind of like returns, too. I'm driven to have my cake and eat it, too.
The takeaways from these exercises?
While arguably valuable as a risk-management tool as part of an overall portfolio management strategy, namely in terms of limiting both the real and psychological pain of massive drawdowns, traders working the Golden Cross and Death Cross, especially for individual stocks, should not expect to enhance returns over a buy and hold model.
Whatever the reasons, if we want to have our cake and eat it, too, we need a different approach.
Readers intrigued by achieving both risk management and results can see where my search leads in the book "Stock Market Cash Trigger."
Addendum: Remember General Electric? As it turns out, trading GE based on the 50/200-day crossover would have resulted in a 42.20% gain over 17 years. That's not much, but beats a buy-and-hold return of -41.30% for the same time period and translates to a 3.4% CAGR (compound annual growth rate). Want to see how I ended up doubling that for GE? It's in the book.
Disclosure: I am/we are long QQQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.