What the Dow’s breaking its 200-day moving average really means for your stocks

The Dow Jones Industrial Average broke below its 200-day moving average earlier this week. Should investors be concerned?

Many stock-market technicians consider the breaking of the 200-day moving average to signal that the major trend has turned down. Devotees like to point out that, by getting out of stocks upon the 200-day moving average being broken, followers would have sidestepped all major bear markets in history.

Sounds impressive, for sure. But there’s a sleight of hand in their argument. To see why, consider that the same argument could be made about any randomly chosen threshold of less than 20%.

Imagine, for purposes of illustration, a threshold of 8.2% (I picked this level out of a hat). Since a bear market is, by definition, a decline of at least 20%, we know that every bear market in history has begun with a decline of 8.2%. So you could say that my threshold protected followers from every bear market.

Yet there’s nothing magical or clairvoyant about my 8.2% threshold. Its alleged ability to protect followers is in fact nothing more than a mathematical fact — a 20% decline is greater than an 8.2% decline.

So the claims made about the 200-day moving average tell us nothing about the real world. Once we focus on the real world, it becomes a simple empirical question: Do followers of this trend-following system fare better over time than investors who adhere to a buy-and-hold strategy?

The answer is no. Over the past century, according to a Hulbert Financial Digest study, the 200-day moving average failed to beat a simple buy-and-hold strategy, on both an unadjusted and a risk-adjusted basis, after taking transaction costs (but not taxes) into account. Over the past 25 years, it has failed to come out ahead even before such costs are taken

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