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Market Timing with Moving Averages

Last Updated on 10 February, 2024 by Rejaul Karim

Exploring the realm of market timing, “Market Timing with Moving Averages” by Paskalis Glabadanidis sheds light on the effectiveness of a third-order moving average (MA) trading strategy. Published on March 12, 2012, and revised on November 9, 2012, the study assesses value-weighted decile portfolios across various financial metrics and industry segments.

Revealing its robustness, the MA strategy consistently outperforms a buy-and-hold approach, yielding significant alphas of 10% to 15% annually after transaction costs. This performance persists across different lags of the moving average, diverse market conditions, and is surprisingly effective with randomly generated and bootstrapped returns. The study extends its insights globally, showcasing the profitability of the MA strategy across international stock markets and individual stocks.

The research concludes by emphasizing the MA strategy’s substantial market timing ability as a key driver of its abnormal returns, positioning it as a unified framework for effective security selection and market timing.

Abstract Of Paper

I present evidence that a moving average (MA) trading strategy third order stochastically dominates buying and holding the underlying asset in a mean-variance-skewness sense using monthly returns of value-weighted decile portfolios sorted by market size, book-to-market cash-flow-to-price, earnings-to-price, dividend-price, short-term reversal, medium-term momentum, long-term reversal and industry. The abnormal returns are largely insensitive to the four Carhart (1997) factors and produce economically and statistically significant alphas of between 10% and 15% per year after transaction costs. This performance is robust to different lags of the moving average and in subperiods while investor sentiment, liquidity risks, business cycles, up and down markets, and the default spread cannot fully account for its performance. The MA strategy works just as well with randomly generated returns and bootstrapped returns. I also report evidence regarding the profitability of the MA strategy in seven international stock markets. The performance of the MA strategies also holds for more than 18,000 individual stocks from the CRSP database. The substantial market timing ability of the MA strategy appears to be the main driver of the abnormal returns. The returns to the MA strategy resemble the returns of an imperfect at-the-money protective put strategy relative to the underlying portfolio. Furthermore, combining several MA strategies into a value/equal-weighted portfolio of MA strategies performs even better and represents a unified framework for security selection and market timing.

Original paper – Download PDF

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Author

Paskalis Glabadanidis
Essential Services Commission of South Australia

Conclusion

In summary, the examination of a third-order moving average (MA) trading strategy unfolds a robust and compelling narrative. Across various dimensions, including market size, valuation metrics, momentum, and industry, the MA strategy consistently outpaces a buy-and-hold approach, showcasing its third-order stochastically dominating characteristics.

The attained abnormal returns, remarkably resilient to influential factors like Carhart’s four factors, investor sentiment, liquidity risks, and market conditions, reveal statistically significant alphas ranging from 10% to 15% annually after accounting for transaction costs. The strategy’s effectiveness extends globally, demonstrating profitability across seven international stock markets and a diverse set of more than 18,000 individual stocks.

Notably, the MA strategy’s prowess in market timing emerges as a primary driver of its exceptional performance, akin to an imperfect at-the-money protective put strategy. The amalgamation of multiple MA strategies into a unified portfolio further accentuates its prowess, positioning it as a comprehensive framework for both security selection and market timing. This comprehensive exploration substantiates the efficacy and versatility of the MA strategy in navigating diverse market conditions.

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Return Chasing and Trend Following: Superficial Similarities Mask Fundamental Differences

FAQ

Q1: What is the primary focus of the paper “Market Timing with Moving Averages,” and what key findings does it reveal regarding the effectiveness of a third-order moving average (MA) trading strategy?

The paper primarily focuses on assessing the effectiveness of a third-order moving average (MA) trading strategy in market timing. The study evaluates value-weighted decile portfolios across various financial metrics and industry segments, aiming to determine if the MA strategy stochastically dominates a buy-and-hold approach. The key findings highlight the robustness of the MA strategy, consistently outperforming the buy-and-hold strategy across different dimensions, yielding significant alphas ranging from 10% to 15% annually after accounting for transaction costs.

Q2: What factors contribute to the robustness of the MA strategy, and how does it perform under various market conditions and international settings?

The MA strategy’s robustness is underscored by its insensitivity to influential factors such as Carhart’s four factors, investor sentiment, liquidity risks, and market conditions. It consistently outpaces the buy-and-hold approach across diverse financial metrics and industry segments, showcasing its effectiveness under different lags of the moving average and in subperiods. Additionally, the study extends its insights globally, demonstrating the profitability of the MA strategy across seven international stock markets and individual stocks.

Q3: How does the MA strategy’s market timing ability contribute to its exceptional performance, and what role does it play in the context of a unified framework for security selection and market timing?

The MA strategy’s substantial market timing ability emerges as a key driver of its exceptional performance, akin to an imperfect at-the-money protective put strategy. This market timing prowess is considered the primary factor behind the attained abnormal returns. Moreover, combining multiple MA strategies into a unified portfolio enhances its effectiveness, positioning it as a comprehensive framework for both security selection and market timing. The study emphasizes the significance of the MA strategy in navigating diverse market conditions and its potential as a versatile tool for active portfolio management.

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