Think of all the financial experts on TV, in books and online as Allison from the movie Get Out. Sure they say all the right things about the market but little do you know they aren’t telling you the entire truth. If you just mindlessly listen and follow their buy and hold investing philosophy it’s like you’re filling your brain with their thoughts and instructions instead of thinking independently for yourself. It’s not quite the brain swap Allison and her family wanted, but it’s pretty close.
Picture me as Rod, I’m no financial expert, I’m just a regular guy here to provide you some common sense advice. If your investment strategy is just buy and hold you expose your portfolio to the tremendous downturns of the market. In 2001 the S&P dropped more than 45% and again in 2008 it dropped more than 55%. You hear that? That’s the spoon in the tea cup whispering to you “buy and hold, buy and hold, buy and hold.”
Don’t let these experts hypnotize you into accepting these catastrophic investment losses. These experts had me in The Sunken Place too, only recently have I rejected their buy and hold mantra. I don’t want to be fully invested when the next bear market comes and watch my portfolio get ravaged. To avoid the devastation I need a signal to alert me that the time is right to move out of equities and into bonds or cash and save my portfolio.
Step 1: Simple Moving Averages
I want a system to confirm long term trends so I used simple moving averages: the 200 day and the 60 day. The system works as such:
- Once the S&P 500 closing price moves below the 200 day moving average and
- The 60 day moving average moves below the 200 day moving average the market has possibly entered bear territory.
These conditions have been met only 8 times since 1993. The small number of occurrences is positive, it indicates the system is a good measure of long term market trends.
Although there have only been 8 signals in the past 24 years, most of the occurrences have been false signals.
In June 2011 the S&P 500 fell under its 60 day moving average and by August it had fallen under its 200 day moving average too. Soon, the 60 day moving average falls under the 200 day moving average creating an Inflection Point. The Inflection Point signals a possible bear market and thus I get ready to start the process of selling my stocks. However this would be an absolutely terrible money losing move since by February 2012 things are back in order: the S&P 500 closes above its 60 day moving average and 60 day moving average is above the 200 day. If I want to use signals to shift my entire portfolio to protect it from a bear market I’ll need more than just simple moving averages.
Step 2: 200 Day Moving Average Filter
Before and after the Inflection Point we can use the direction of the 200 day moving average as a filter. The rules for the filter are:
- Condition 1: Accept signal if the 200 day moving average trending down before and after the Inflection Point
- Condition 2: Reject signal if the 200 day moving average is flat or moving upwards after the Inflection Point
- Condition 3: Accept signal if the 200 day moving average is trending upwards before the Inflection Point and the downwards after
Below is a table of the results of the eight Inflection Points since 1993 and the movement (before and after) of the 200 day moving average.
In 2011 and 2015 the 200 day moving average trends slightly up prior to the Inflection Point and then slightly down afterwards (meeting Condition 3). Under the first two steps both signals would have been accepted. However, a bear market does not appear after either signal so another step is needed to filter out false signals.
Step 3: Closing Price Movement
The last filter looks directly at the price action of the S&P 500 after the Inflection Point.
As you can see in 2000 and 2008 the price continues a severe downward slide after the Inflection Point. Not for one day did the S&P 500 close above the Inflection Point’s close. This downturn in the price confirms the market is heading downwards so I accept the signal.
The 2011 the price action looks weak, but no where near as severe as what was witnessed in 2000 and 2008. This looks like a simple market pullback, not the start of new bear market, thus the signal is rejected.
2015 looks like a head fake, after the Inflection Point the price action is moving mostly upwards. The upwards movement is all the proof I need to reject the signal. This last filter clearly and concisely eliminates the last two false signals.
Step 4: Returning to the Market
So now that I’m out of the market the obvious question is when do I get back in? I reenter the market when the close and the moving averages get back in proper order. Proper order is when the S&P closing price rises above the 60 day moving average and the 60 day moving average move above the 200 day. This is the signal to get back in.
- Step 1: The price action creates an Inflection Point: the S&P closes below the 60 day moving average and the 60 day moving average moves below the 200 day
- Step 2: Test the movement of the 200 day moving average before and after the Inflection Point. In general if it is rising reject the signal and if it is moving downwards run the signal through the filter in Step 3.
- Step 3: Over five day increments record how many days the S&P closes above or below the Inflection Point’s close. If the S&P continues to mostly close above the Inflection Point’s close then reject the signal. If the S&P closes consistently below the Inflection Point’s close then accept the signal.
- Step 4: Reenter the market when the closing price rises above the 60 day moving average and the 60 day moving average is above the 200 day.
Is This Timing the Market?
I do not consider this a timing the market strategy, I know of no one who can do that. Moving averages are lagging indicators, meaning it just supports a trend that is already in motion. By the time this strategy kicks in the S&P 500 index should already be down significantly from its peak. The goal of this strategy is to sacrifice and lock in that 5% or 10% loss in order to avoid a 40% or 50% loss. This system is not picking a top or bottom in the market.
Fortunately bear markets have proven to be rare occasions. Unfortunately when they do occur there is no advantage to being long the market. These deep declines decimate the average investor’s portfolio and it has been shown it takes years and years just to get back to even. I can’t just lie down and allow the next bear market to decimate the value of my portfolio.
It’s important to note I’m applying this system to the S&P 500 index, not an individual stock. I’m pretty confident such a system would not work on individual stocks because they are typically much more volatile. This system works in theory because it is piggybacking on massive long term trends that transcend for years. I’m confident it would work on the Nasdaq or Russell 2000, not so much on individual stocks like GE, Disney or IBM.
This system isn’t fancy of bulletproof, I may find ways to upgrade it in the future. For now it is the best system I have and I will definitely be in tune to the 50 day and 200 day moving averages of the major indexes going forward. I want to do everything in my power not to get caught up in the next bear market.