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Is The 200 Day Moving Average Hokum?

Mitigating the flaws of a defensive strategy.

Ben Carlson had a write up in Bloomberg that took down using the 200 day moving average (DMA) as a sell indicator. Ben notes there have been far more breaches of the 200 DMA than there have been corrections or large declines. He concedes the indicator would have helped during the last two bear markets but that the false positives can compound into missing important upside along the way.

As I read the article he appears to be talking about getting out completely when a breach occurs. This is a very widely followed and written about sell indicator but the context always seems to be all or nothing which I agree is a poor strategy. There are a lot of false positives and so whipsaw is a high probability. This is why I have always talked about incremental defensive action. The history of bear markets is they tend to start slowly. There is no reason to radically alter your portfolio on day one of a breach for several reasons.

The first reason is that a bear market may of course not be forthcoming. Accurately calling a bear market is very difficult to do. I sort of did it once (December 2007) but I have no expectation of being lucky enough to publicly call one again. It is much easier to maintain a disciplined approach to taking slow defensive action when the chances for a large decline have increased. Long time readers may know I rely on just three things; a breach of the 200 DMA, an inverted yield curve, triggering of the 2% rule (average 2% decline three months in a row) or any combo of the three. I view these all as simple.

I've written about how I do this many times but if the S&P 500 looks like it will close below its 200 DMA for a second day in a row I will usually buy an inverse fund. That has not always been the first trade and I would say what I do first doesn't matter a whole lot, so long as I do stick to the strategy. The reason I like inverse funds is if the market does start to really drop, a position in an inverse fund should grow relative to the portfolio thus hedging more of it.

Additionally, many clients own the Pacer TrendPilot 750 (PTLC) which will switch from long equities to T-bills after five days below the 200 DMA. The combination of one inverse fund and PTLC alone is enough to create a noticeable, not huge, buffer relative to a large drawdown in the market. I've talked about the AGFiQ US Market Neutral Anti-Beta (BTAL) as playing a role the next time I need to take defensive action. It could be a second or third trade but it is a small fund. If you ever have interest in buying a small ETF and the spread is wide, try calling your broker to see if they can get a tighter spread for you. There is one other inverse fund I am considering and will let you know if/when I ever add that one.

I do believe that three of these products as outlined above plus PTLC switching to cash could be most of the trading needed but to be clear these could be put on over several months. Bear markets give you a long time to get out, look at the last two and see for yourself. This strategy doesn't really work well for crashes or other very fast decline. Crashes have historically been better to buy.

Selling something as part of a defensive strategy seems to be obvious but after nine years of gains, that is trickier for non-qualified accounts. I buy with the intention of holding a long time, a little over one third of the names I own for clients (just eyeballing very quickly) have been held longer than ten years. Since the low, the S&P 500 is up about 230%, even mediocre performers are up a lot.

Any strategy, defensive or otherwise, will have flaws. The point is to understand the flaws and then mitigate them as best you can. If the flaws of a strategy are too great in your estimation then that strategy isn't for you. You may draw a similar conclusion as Ben does about the 200 DMA. Many investors take no defensive action which is perfectly valid. Do what you believe in and most importantly stick to it in a disciplined fashion,