Last Updated on 9 January, 2023 by Samuelsson
Following the trend of the S&P 500 may not seem exciting. However, in a paper published in 2012, Meb Faber discovered that the 200-day moving average could be useful in this regard. He proposed a basic trend following system for the S&P 500 that involves buying when the price crosses above the 200-day moving average and selling when it falls below it. This strategy may seem too simple to be effective, and it has been neglected by many traders for the past 7-8 years. Despite its simplicity, Faber’s approach has proven to be powerful. The temptation to pursue more complex strategies is always present in the minds of traders.
This strategy, known as trend-following, only considers the price and ignores other factors such as news, earnings, valuations, sentiment, and interest rates. It is based solely on the market’s current movements, regardless of expectations. The algorithm used is also very straightforward.
200-day moving average
The use of a simple moving average as a trend filter is a straightforward and easy principle. Meb Faber’s 200-day moving average strategy is so simple that anyone, including non-traders and investors, can understand it within seconds. Paul Tudor Jones, a famous trader, once mentioned in an interview with Michel Covel that he uses the 200-day moving average of closing prices as a metric for everything he looks at. According to Jones, the 200-day moving average helps him avoid losing everything by getting out of potentially risky investments. While Jones’ trading strategy may be more complex than just using this filter, it demonstrates the effectiveness of even the most basic techniques. However, Jones is not a fan of trend following as he believes markets often do not trend. It is worth considering if using this trading system may result in missing out on potential profits in the long term.
Trend following – S&P 500 – daily data
Let’s examine the performance of a 200-day moving average on the S&P 500 by beginning our test.
The trading strategy for the S&P 500 involves buying when the closing price is above the 200-day moving average and selling when it falls below. The equity curve shows a maximum drawdown of 28% in 2002 and a compound annual growth rate of 6.73%, compared to a 7.16% buy and hold strategy (not adjusted for dividends). While the S&P 500 may not show significant short-term fluctuations, it tends to trend upwards in the long term. This strategy successfully avoided the 2008/09 global financial crisis by selling in December 2007 and reentering in June 2009, thanks to Paul Tudor Jones’ “defense logic.” During the Covid-19 pandemic, the strategy bought on March 2, 2020, sold the following day, bought again on March 4, and sold again on March 5 before remaining on the sidelines until late May. The maximum drawdown during this period was 19%.
Trading the S&P 500 using a trend following strategy based on monthly data
If we base our strategy on monthly data, we will follow the following plan: when the closing price surpasses its ten-month moving average, we will invest in a long position. On the other hand, if the closing price falls below the ten-month average, we will sell. The resulting equity curve will resemble the following:
An investment of 100,000 in 1960, compounded but not including dividends, is now worth 5.158 million. The largest drop occurred during the 1987 crash, with a decline of 26%. The strategy has a compounded annual growth rate of 6.56%, slightly lower than the buy and hold strategy, which has a growth rate of 7.16%.
What is the conclusion about following the trends of the S&P 500?
Meb Faber and Paul Tudor Jones both believe in the effectiveness of the 200-day moving average as a useful tool for making investment decisions. It may not be the best indicator, but it is a straightforward method for avoiding risk during turbulent times. Additionally, following the trend of the S&P 500 with the 200-day average can lead to relatively good returns in the stock market over the long term.
In summary, trend following strategies such as the 200-day moving average can be a simple yet effective way to navigate the stock market. By considering only the market’s current movements, rather than attempting to predict future events or analyze individual company fundamentals, traders can potentially avoid risk during times of uncertainty. While this approach may not always result in the highest returns, it can provide a consistent method for generating profits over the long term. It is important to note, however, that no investment strategy is without its risks and it is always crucial to thoroughly assess the potential risks and rewards before making any investment decisions.