A Primer on the 200-Day Moving Average

Is it really a bull signal? James Altucher explains it for you, and shows a contrarian way to play it.
By James Altucher ,

Editor's note: This column is a special holiday bonus for readers of TheStreet.com, written by James Altucher of Street Insight. To sign up for Street Insight, where you can read Altucher's commentary regularly, please click here.

Over the past month, the media have had a field day referring to the200-day moving average. As in:

"The

S&P

index just crossed its 200-day moving average. This is a very bullish sign."

"

Microsoft

(MSFT) - Get Report

crossed its moving average, so we should expect to see anice upwards move over the next week."

I was skeptical. It doesn't seem to make sense to me that this would bea bullish event. Most of the time when I read or hear about the 200-day movingaverage people are talking about the entry -- or the crossover of theaverage -- but never the exit, so it was hard to formulate a successfultrading strategy.

Also, I was never sure what people meant by the word "bullish." Doesthis mean the market goes up forever now -- or just tomorrow?

To make sense of things, I decided to take a closer look at the 200-daymoving average, what it signals and exactly how "bullish" it is. In general,my focus as an investor and hedge fund manager is to develop a hypothesisabout the markets, whether based on fundamentals or price action, and test,test, then test again. No words of wisdom, or so-called 'truisms', aboutstock or indices are above being rigorously studied and verified as best onecan before investing money.

I ran a few tests to get to the bottom of the 200-day moving average.I attempted to mirror and test the media prognosticators who forecast thechange in trend with each move in the 200-day moving average. As you willsee later on in this column, I came up with a long-only system -- in other words, it's only good for the long side of the market -- for using the 200-daymoving average as a

countertrend

indicator that has worked well inboth bull and bear markets.

But first things first: What is the 200-day moving average?

Simply put, it's the prices of a stock, or market index, the prior 200days, added together and divided by 200. As can be seen in the following chartof the 200-day moving average -- the brown line -- most of the time when weare in a bull market, the closing daily price of the S&P is above the200-day moving average. And most of the time when we are in a bear market, theclosing price of the S&P 500 is below the 200-day moving average.

S&P 200-Day Moving Average
The 200-day in relation to bull/bear markets.

The real question is, when the daily price of the S&P closes over the200-day moving average, are we also moving from a bear period to a bullperiod?

To see if this trend-following assumption is true I ran three tests,labeled A, B and C. Here are the tests and results:

Test A:

Buy the S&P when the close crosses over the 200-daymoving average. Sell when the S&P crosses below the 200-day moving average.I felt this most closely mirrored what the media is forecasting when theymention this average.

Result:

It's hard to qualify this as "bullish," but the resultsdo yield positive returns. The winners are often huge wins and the losingtrades are relatively tiny.

However

, only 28% of the occurrences ofthis system haveresulted in a positive trade. In other words, if the S&P closes above its200-day moving average, then there is a 72% chanceit will be lower by the time it goes below its 200-day moving average. Thatsaid, doing this trade on every occurrence since 1950 would've made aninvestor money in the long haul:

Of the 142 occurrences since 1950: Forty successful, 102 unsuccessful,with an average return per trade of 3.23%, including the losses. If you puta $10,000 put into this system in 1950, it would be worth $55,000 today. Ifyou put a $10,000 put into a buy-and-hold strategy, however, it would beworth $494,000.

There have been many false starts to this indicator -- particularlysince Jan. 1, 2000, with 17 occurrences and only two successful. Thisincludes the most recent occurrence, which opened April 21 and hasn'tclosed yet. So when someone says "we just crossed over the 200-day movingaverage so now we are in a bull market," it's best not to believe it.

Buy Above the 200-Day, Sell Below
Only 28% of the trades in this test resulted in a positive outcome.

Source: James Altucher

Click here to see larger image.

Test B:

Buy the S&P when the close crosses the 200-day movingaverage, and sell one day later. The idea here is: Maybe people get so excitedabout the event of the crossing that they rush to buy.

Result:

Mildly positive, but not statistically significant anddoes not beat commissions and slippage. Of the 147 occurrences (not 142like before?) since 1950, 74 were successful and 73 were unsuccessful, withan average return of 0.11% -- equivalent to 1 point in the S&P today.

However, the results get a little better when you buy the 200-daycrossover and hold for one month. Under these circumstances, you have a 72%success rate with an average gain of 1.65% as opposed to the 0.68% averagemonthly return since 1950. The last trade in this system started on April17 and ended on May 16, for a gain of 5.68%.

So perhaps it is bullish when the S&P 500 crosses its200-day moving average and you hold for a month. Basically, you get doublethe return per trade of random buy-and-holding for a month.

Holding for a quarter doesn't improve the results: You would get 2.67% pertrade as opposed to an average quarterly return of 2.04% since 1950.

Test C:

What happens now if you run the "one-month" system described in test B on a basket of your favorite stocks? Buy a stock when itcrosses its 200-day moving average, and sell one month later.

I ran the test on the stocks in the S&P 400 mid-cap index over the pasteight years. I ran it as a simulation where each trade took up 1% of equityand tabulated the results. Results were marginal: an average return of0.62% per trade with the following yearly returns demonstrating that youwould've survived the worst of the bear market but still taken a big hit in2002.

S&P 400 Mini-Cap Index
Buying a stock when it crosses the 200-day and selling a month later offers marginal results.

Source: James Altucher

In general, although conceptually it does seem bullish when the indicescross their 200-day moving averages, it does not seem like there is aworthwhile trading strategy that results. Tests A, B and C bore littlefruit.

One More Try

I decided to try one more approach. A contrarian one that depends onthe concept of mean reversion -- i.e., when the price of the S&P hits anextreme low relative to its 200-day moving average, one should buy.Specifically:

Buy when the S&P closes 20% below its 200-day moving average (e.g.,the crash of 1987 or on Sept. 20, 2001) and

sell

one month (20 trading days)later. Very simple.

Result:

Since 1950, if you made this trade in all 79occurrences, 65 of which were profitable (82%) and 14 unprofitable (17%),for an average return of 6.43% per trade as opposed to a return of 0.68% ifone randomly buys any month. Not bad.

It gets even better when you measure more recent history. If you lookat the data for the S&P 500 index since 1975, this system would've resultedin 34 out of 34 successful trades with an average return of 10% per trade.The last trade started on Oct. 10, 2002, ended on Nov. 7, 2002 -- andreturned a nice 12.28%. That's enough to pay the bills and have a niceglass of wine to celebrate.

Arguing about the trend of the market based on the 200-day movingaverage might be fun at cocktail parties (depending on your definition offun) but won't really make anyone money. Instead, buying when the trend isabsolutely, unequivocally

down

and the market is plummeting

vis avis

its 200-day moving average is usually the best time to take a trade onthe long side. By the time the talking heads are debating a new trend whenprice closes above the 200-day moving average you are long gone out of themarket, hopefully on vacation.

James Altucher is a partner at Subway Capital, a hedge fund focused on deep value and arbitrage opportunities, where opportunities are identified using proprietary software. Previously, Altucher was a partner with technology venture capital firm 212 Ventures and was CEO and founder of Vaultus, a wireless and software company. He holds a B.A. in Computer Science from Cornell and was a Ph.D. candidate in Computer Science at Carnegie Mellon University.

Loading ...