March 8th, 2008

Momentum Trading vs. Buy-and-Hold

As predicted, the S&P 500 Index’s 180-day moving average crossed below its 300-day moving average this past Friday confirming the market’s momentum as clearly pointing towards further significant declines.

I’ve been writing here about a simple market momentum timing tool I constructed using a series of moving averages and back tested against nearly 50 years of market history. The indicator dictated on December 28 that you should be out of the market and invested mostly in cash. Since that time, the indices have had dramatic declines:

And yet, even after the major indices have shown dramatic declines year-to-date, we continue reading articles pushing (probably not all that objectively, either) that old panacea, the buy-and-hold strategy.

For example, in Sunday’s New York Times Business Section, Mark Hulbert wrote in his Strategies column an article entitled “Can You Beat the Market? It’s a $100 Billion Question” ends with this “bottom line”:

“The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you.”

Hulbert describes a new study by Kenneth French, a Dartmouth finance professor and some-time partner of Eugene Fama of my alma mater, the U. of Chicago Graduate School of Business, entitled “The Cost of Active Investing”. French concludes that individual investors can increase their returns by putting their money in investments with lower management and transaction costs like Index Mutual Funds.

I couldn’t disagree more vehemently. Investors just haven’t been provided with an effective tool for dealing with the dynamic nature of market momentum. Over the years, I’ve perused (can’t say I’ve studied because, I confess, the mathematics are overwhelming to me) many academic studies purportedly test technical analysis and market timing strategies. Most, however, are static rather than dynamic. They assume either fixed periods and inflexible rules.

My Market Momentum Timing Indicator dictates that whenever the market action meets certain market characteristics, the prudent course of action is to be in cash. Had you followed the specified action on December 28, you’d have avoided the losses in the above table and have more than 10% investable funds than those who followed the buy and hold strategy. While all you hear is “with the market declining, what should you be invested in?” That’s Wall Street’s perspective …. what can I sell you now. Why not just ask, “with the market declining, should I be in cash?” Wall Street can sell me some stock, but not until after the market’s bottomed and then I’ll buy more stock than had I stayed fully invested through the decline.

The Indicator will tell us when the market’s decline is probably over but, if you don’t catch the actual bottom or near it, the market could increase over 10% from current levels before jumping back in and you’d still be even with the buy-and-holders. Getting in at anything less than 10%, you as a market momentum trader will be ahead of the game.

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