Figure 1
It becomes apparent after a quick study of a long-term price chart, like Figure 1 above, that markets tend to trend – either upwards, or sideways-to-downwards and are not random. If an investor had purchased stocks at the bottom of each of the secular bull markets since 1900 and sold them at the top of the bull market, then the investor would have earned an annualized real dividend re-invested return of 5.1% versus 3.2% if they had simply bought and held stocks for the entire century. If the investor had shorted stocks during the secular bear markets, the investor’s real return would have increased to 6.9%. But it is impossible to time the markets this way, you may be thinking. To be this accurate, maybe not, however there are trend-following and trend forecasting techniques that have been shown to capture 25% to 50% or more of a trend and/or keep one’s portfolio out of trouble.
To illustrate this, a simple trend-following system constructed from a S&P 500 45 day moving average is shown along with its profitability from January 2008 to August 2010 in Figure 2 below. A buy signal is given when the S&P 500 crosses above the moving average line and a sell signal is given when the S&P 500 crosses below the moving average line. There is some filtering that has been included to reduce false signals. This simple trend-following system has provided an annualized return from January 2008 thru August 2010 of 21.8% versus an annualized 14.3% loss for the S&P 500 buy-and-hold investor. In addition, the maximum drawdown of this strategy was 13% versus 56% for the Buy-and-Hold strategy using the S&P 500. The green bars on the top graph show the growth of the initial $100,000 to $165,000.
Figure 2
