Users: gnc: Significance of 200-day moving average - Mark Hulbert - MarketWatch

By Mark Hulbert, MarketWatch

CHAPEL HILL, N.C. (MarketWatch) — Does the breaking of the 200-day moving average mean the stock market’s major trend has turned down?

That was certainly the worry on June 1, when both the Dow Jones Industrial Average /quotes/zigman/627449 DJIA -1.14%   and the S&P 500 /quotes/zigman/3870025 SPX -1.26%   closed below this crucial technical level.

Adding to this worry was the very real concern that the violation of that level would precipitate a waterfall decline — triggered by the many mechanical trading programs automatically keyed to the breaking of this moving average. ( Read blog post about such worries. )

To be sure, the market defied those worries and almost immediately turned back up, and for the last week has remained above its 200-day moving average.

But on Monday of this week the market fell back to within shouting distance of that average — and any day’s trading session now carries the very real potential of that average being broken again.

Should you care?

The answer, unfortunately, is complicated. On the one hand, market timing systems based on the 200-day moving average have impressive long-term results. On the other hand, those systems have become markedly less successful in recent decades — and over the last couple of decades have markedly lagged a buy-and-hold.

That at least is what I found upon back-testing the 200-day moving average back to the late 1800s, when the Dow was created. Specifically, I constructed a portfolio that was fully invested in the Dow whenever it was above its 200-day moving average, and otherwise was on the sidelines earning nothing. (Notice carefully that I took into account neither the dividends earned by this portfolio when invested in stocks nor the interest on the cash it held when out of the market.)

The long-term results were quite impressive. Compared to a 5.0% annualized return for buying and holding over this 115-year period, the 200-day moving average portfolio earned a 6.6% annualized return. Better yet, this outperformance was produced while simultaneously reducing risk by a big amount.

Unfortunately, this moving-average system has been an even bigger disappointment over the last two decades. From the beginning of 1990 through Monday’s close, for example, this hypothetical moving-average portfolio made just 4.0% annualized, compared to 6.8% annualized for buying and holding. The money-market interest the moving-average portfolio would have earned while out of the market would not have made up this difference.

I am not the first to notice this diminution in the 200-day moving average’s profitability. A number of academic researchers have documented it as well, noting that it began to lose its effectiveness in the stock market at the same time it stopped working in the foreign-exchange markets as well.

In their opinion, this increases the likelihood that whatever caused the moving average to become less profitable in the stock market was more than just a fluke.

What might the cause of that be? The most likely culprit, according to those researchers, is the 200-day moving average’s increasing popularity. As more and more investors begin to follow a system, of course, its potential to beat the market begins to evaporate.

The bottom line? Unless you have good reason to believe that the last two decades were a mere exception and not the new rule, you may want to think twice before buying or selling stocks based on whether the market is above or below its 200-day moving average.

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Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.