I offer analysis in this blog motivated by a reply to a tweet I made yesterday regarding the essence of the 200-day moving average. I show that the choice of a 200-day moving average for the purpose of stock-bond allocation is sub-optimal. Furthermore, any reduction in drawdown levels can be attributed to the asset allocation rather than to some particular choice of moving average.
This is the tweet I made yesterday and a reply from Jake:
@mikeharrisNY allocate to stocks when above and bonds when below over longer periods, you get almost all return with 1/3 the volatility
— Jake (@EconomPic) June 30, 2015
Let us investigate Jake’s claim. Basically Jake suggested this strategy:
If price of SPY > 200-dma then sell TLT and buy SPY sell SPY if price of SPY < 200-dma and buy TLT.
I used initial capital of $100K, fully invested equity and $0.01/share commission. The backtest starts at the inception date of TLT, which is 07/30/2002. Below is the portfolio equity and underwater equity curve:
Maximum drawdown is about half of what is realized by a buy and hold strategy in SPY. Obviously, risk is reduced because a -29% maximum drawdown is much better than a maximum drawdown of -56% for the buy and hold case. The buy and hold CAR in the tested period for SPY is 8.81% and CAR for the allocation strategy is 7.05%, actually not too bad considering the 50% reduction in maximum drawdown.
However, the objective of this blog is to show that the choice of the 200-day moving average is not special. To achieve that, I repeated the backtest for values of the moving average between 100 and 500 in increments of 20 days. Below are the results of the optimization:
As it turns out the choice of a 200-day moving average is arbitrary and sub-optimal. A 100-day moving average results in the highest CAR of 11.38% at an even lower maximum drawdown of -17.13%. Below is the portfolio equity and underwater equity curve:
Therefore, I stand by my claim that the 200-day moving average was an invention of financial journalists that maybe later became a sort of (unsuccessful) self-fulfilling prophecy. In reality, the benefits of lower risk are inherent in the general allocation scheme and have little to do with the choice of moving average, except for values above 300 days where a large lag kicks in and drawdown levels increase.
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