Avoid Market Crashes

One winning strategy is to buy a low-cost broad index fund/ETF like SPY and be done with it. You now own a piece of all successful companies in the United States.

An index, however, provides no downside protection. If you need to sell after a decline, you will lose. You will lose if you panic or respond emotionally after a market decline.

What about winning by not losing? Is there a way to avoid or reduce the market decline? Perhaps. Let’s explore.

Markets tend to persist in a pattern after gaining some momentum. They tend to trend up/down or stay within a range. Could we identify a signal to help us decrease our equity holdings before most losses occur?

A Value Investor’s View

I admit I entered this field with extreme skepticism. I’ve been steeped in traditional Graham-Dodd value investing for over four decades. Ben Graham put no credence in technical stock trading or charting. Warren Buffett and Jack Bogle agreed. For the most part, they are right.

But my views evolve as new information comes along. One vital factor came with the discovery of momentum as a legitimate factor. If you tilt your portfolio to small companies, value, or quality, then you should also pay attention to momentum. That factor is at least as predictive as value and small. So why pick and choose our factors randomly?

That work gave a theoretical foundation to chart signaling. It also jives with my understanding of humans. We tend to look to others for social proof, follow groups, and maintain trends. Once price changes gain traction and momentum, it takes a large countervailing force to alter them.

Such a signal should help us enter near the start of an uptrend and exit at the beginning of a downtrend. It should create big winds and small losses.

We want a reactive signal to achieve these goals without overtrading. Frequent trading takes time and incurs transaction costs.

Simple Moving Average

Such a signal may be a Simple Moving Average. A simple moving average is based on the mean of a fixed number of data points. As numbers trend up, the moving average will trend up. It moves slower than the numbers to reduce the data’s noise (meaningless volatility) and highlights persistent trends.

For example, the 5-day SMA could be calculated as follows:

$100 + $102 + $98 + $101 + $99 = $500/5 = $100

Some stock traders create other averages, such as exponential moving averages (EMA) or weighted moving averages (WMA), but we will focus on the SMA. Some also temper their trades based on the relative strength index (RSI) or convergence/divergence (MACD). We can skip those for this intro on trend following.

Avoid stock market crashes.

Get out at the start of a secular bear market.

It can be done.

“I am always thinking about losing money as opposed to making money.” -Paul Tudor Jones

Meb Faber

Meb is a well-respected wealth manager and researcher. He uses trend following to his advantage. He wrote a landmark whitepaper: A Quantitative Approach to Tactical Asset Allocation by Meb Faber :: SSRN

Moving-average-based trading systems are the simplest and most popular trend-following systems (see, for example, Taylor and Allen (1992) or Lui and Mole (1998)). For those unfamiliar with moving averages, they are a way to reduce noise. The example below shows the S&P 500 with a 10-month simple moving average (SMA).

BUY RULE

Buy when monthly price > 10-month SMA.

SELL RULE

Sell and move to cash when monthly price < 10-month SMA.

Each week, there are five trading days, Monday through Friday. Over a month, there are four weeks. That makes for 20 trading days on average per month. So, 200 days is about ten months. Faber looks at a 10-month simple moving average since it is simpler and easier than the 200-day moving average. The 10-month SMA strategy has shown promising results:

1973 – 2008

For the S&P 500 Index from 1901 to 2012, the 10-month SMA timing rule generated a gross annualized return of 10.2% compared to 9.3% for buy-and-hold, with lower volatility (12.0% vs 17.9% annual standard deviation).

The maximum annual drawdown was reduced from -83.5% (buy-and-hold) to -50.3% (SMA strategy).

The study mentioned in the results also tested 3-month, 6-month, 9-month, and 12-month SMAs:

Based on the Sharpe ratio, timing strategies using these SMAs consistently outperformed buy-and-hold.

Jim Otar

In his book Unveiling the Retirement Myth (currently $593 on Amazon), financial planner and researcher Jim Otar points out that avoiding secular bear markets enriches investors. He repeats that most gains occur on only a few trading days. He counters with data that the largest losses happen in a few days, too. However, the losses are more harmful and take longer to recover. If you are hoping to ‘miss’ or ‘not to miss’ anything, it is better to miss the worst months than not to miss the best months.

He doesn’t consider himself a chartist or market timer. He compares observing market conditions, trends, and averages to common sense. Before heading out, do you check the weather forecast or look at the sky? Dark clouds or a rain forecast may encourage you to pack an umbrella. Such observations protect you from a downpour and ending up soaking wet. Similar with the markets.

Otar prefers 5-Month SMA for his current pricing and a 12-Month SMA for his long-term trendline. If the 5-month MA is lower than the 12-month MA and the 12-month MA is declining, then markets may be going into a bearish trend. Go defensive. Otherwise, stay aggressive. It is slightly more complicated than a 10-month or 200-day SMA, but manageable. He outlines how to enter the closing prices into a simple Excel spreadsheet to give buy and sell signals.

He back-tested a $1,000 investment using his system.

01/01/1900 – 12/31/2008

The 5-month/12-month crossover trading strategy provided much higher growth and less risk (since it invested in cash for 400 months).

Jeremy Siegel

The 200-day simple moving average is the most often cited long-term trend measure in the technical analysis community. In his 2008 book Stocks for the Long Run 5/E, Jeremy Siegel investigates the use of the 200-day SMA in timing the Dow Jones Industrial Average (DJIA) from 1886 to 2006.

His test bought the DJIA when it closed at least 1 percent above the 200-day moving average and sold it, and invested in Treasury bills when it closed at least 1 percent below the 200-day moving average. He concludes that market timing improves the absolute and risk-adjusted returns over buying and holding the DJIA.

Likewise, when all transaction costs are included, the risk-adjusted returns are still higher when employing market timing, though timing falls short on an absolute return measure.

The strategy would have allowed the investor to avoid the Great Crash (1929-1932). Investors would have ridden the bull market from 1924 and exited on October 19, 1929, just ten days before the Great Crash. They would reenter on August 6, 1932, at just 25 points higher than the low. The system also avoided the October 19, 1987, crash by exiting the previous Friday, October 16.

The system reduced risk. “Since the market timer is in the market less than two-thirds of the time, the standard deviation of returns is reduced by about one-quarter.” The risk-adjusted returns of the 200-day moving average strategy are quite impressive.

Siegel does not report drawdown figures, which would have further demonstrated the superiority of the timing model.

1926 – 1945

Paul Tudor Jones

“One principle for sure would get out of anything that falls below the 200-day moving average.”

– Paul Tudor Jones

We can learn from the billionaire hedge fund manager Paul Tudor Jones. “I teach an undergrad class at the University of Virginia, and I tell my students, I’m going to save you from going to business school. Here, you’re getting a $100k class, and I’m going to give it to you in two thoughts, okay? You don’t need to go to business school; you’ve only got to remember two things. The first is, you always want to be with whatever the predominant trend is.

My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: How do I keep from losing everything? If you use the 200-day moving average rule, then you get out. You play defense, and you get out.”

Steve Burns

Steve and Holly Burns wrote about a simple trading system in their book “5 Moving Average Signals That Beat Buy and Hold.” Their simplest method is the 200-day SMA (simple moving average) based on monthly closing prices. The system’s signals are based on the month-end only rather than the day of the cross. This is a slow, long-term system. It produces only twelve signals annually and is easy to implement, filtering out many false signals.

If the price crosses and closes over the 200-day SMA, go long. If the price closes under the 200-day SMA, go to cash. Simple. Check for guidance only twelve times yearly.

How does such a simple system perform in various markets? Burns backtested using ETFreplay.com.

01/03/00 – 12/09/2016

The system nearly tripled the returns while cutting drawdown by over two-thirds.

03/24/00 – 12/30/11

10/11/07 – 03/09/09

The system avoided big losses and cut drawdowns by over 90%.

Long trades have a better probability of success when above the 200-day SMA. A loss of the 200-day SMA is your first warning of a possible correction, downtrend, or bear market. This fact alone can save you from significant losses. This risk management tool will help you avoid the most critical market drawdowns and devastating losses. Bad things happen to positions below the 200-day SMA.

I don’t advise individual stock purchases. But know that exiting Enron, WorldCom, or Lehman Brothers when prices fell below 200-day SMA would have preserved enormous capital.

A signal above the 200-day SMA will help you benefit from the next bull market.

“I always check my charts and the moving averages prior to taking a position. Is the price above or below the moving average? That works better than any tool I have. I try not to go against the moving averages: it is self-destructive.” – Marty Schwartz

Brian Livingston

Livingston’s book, Muscular Portfolios, focuses on diversified ETF investing with momentum. He paid tribute to Meb Faber and showed the Ivy 5 Portfolio results. It was from his book The Ivy Portfolio and is based on a 10-month SMA strategy. It was meant to mirror a university endowment with only five assets. 20% of each consisted of US stocks (VTI), developed markets (VEU), commodities (DBC), real estate (VNQ), and bonds (BND). It ran with a straightforward hedging rule. If any ETF’s price at the month-end was below the average of the last ten monthly closes, Treasury notes were held the following month instead of that ETF. Simple, right? How did it do? Not bad.

01/01/2007 – 12/31/2012

Did you lose over 7% during the Great Financial Crisis (GFC)? Most did. Yet this simple 5-part formula with a monthly check-in would have kept you safe.

Faber later increased the asset number to 9 and 13 with even better results. Many muscular portfolios in Livingston’s book were based on the expanded Faber portfolios.

Warren Buffett

He is the archetype for the classic Buy and Hold investor. But is he? Granted, he does not try to time markets perfectly. But if he never tried to time the market, he would always be invested 100%. Maybe he values the market rather than time it. He wants to buy more when prices are high and less when the market is “overpriced.” He isn’t a fan of the strong version of the EMH.

“The first rule of an investment is don’t lose [money]. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.” – Warren Buffett

So, how do you avoid losing money? Is he suggesting we should minimize investing when a crash is coming? How could we foretell the future? That’s impossible. Maybe not. His cash holdings tell a story.

Present and Future

Much research was done up until 2012. How useful has the timing system worked since? Would it help prevent losses in 2020 or 2022? Yes, it continued to work well. Look at the graphs below. Do you see when prices fell below the 10-month moving average? Don’t you wish you got out-of-stock investments then? Do you know when the price goes above the 10-month moving average? Don’t you wish you got back into stocks then?

The strategy, referred to as a 10-month simple moving average (SMA) rule or trend-following strategy, has been widely discussed in investment circles for its ability to avoid large drawdowns in equity markets. Historically, it has been shown to reduce downside risk and increase risk-adjusted returns.

Why the Strategy Works

1. Bear Market Avoidance: The rule effectively signals exit during prolonged bear markets by reacting to sustained downward trends.
2. Behavioral Advantage: It imposes discipline, helping investors avoid emotional decision-making during market turbulence.
3. Risk Reduction: Historical studies indicate this strategy reduces portfolio volatility and drawdowns, though it might underperform during strong bull markets.

Key Considerations

1. Whipsaw Risk: This strategy may generate frequent buy/sell signals in choppy markets, leading to higher transaction costs and potential tax implications.
2. Lagging Nature: Moving averages are lagging indicators, meaning the strategy often enters or exits after significant moves.
3. Missed Gains: You may miss sudden recoveries by sitting out of the markets during false breakdowns.

Despite these drawbacks, the strategy can be helpful for investors in prioritizing loss avoidance over maximum returns.

What do you think? Do you agree? Have I stumbled on the holy grail? Could avoiding financial disasters be this simple? Maybe it is so good that I should keep it to myself. If everyone followed it, then it wouldn’t work, right?

Additional References:

Avoid Equity Bear Markets with a Market Timing Strategy – Part 1 – QuantPedia

Top 3 Technical Indicators for the Bearish Market- ICICI Direct

Technical Analysis – 3 Bullish And Bearish Takes – RIA

Bear vs Bull Traps: Strategies to Dodge Market Deceptions

(3) Best Technical Analysis Strategies to Know When a Bear Market is Over | LinkedIn

Bear Traps: What They Are and How to Avoid Them in Trading

Asset Allocation Based on Trends Defined by Moving Averages – CXO Advisory