Financial Literacy

Technical Tuesday: How to Stick With the Long-Term Trend

A Note From the Editorial Director: We’re often asked about the difference between fundamental and technical analysis. So when Chris Rowe, an expert technical analyst, saw Alex Green’s classically fundamentalist column yesterday on “The Four Best Ways to Beat the Market,” he couldn’t help but to offer his own technique. As Chris explains, what follows cannot be called a formal Oxford Club recommendation. But for those interested in market technicals, his insights are important.

– Andrew Snyder

Today I’ll use technical analysis to show you the easiest approach I’ve ever seen to outperforming the stock market on a long-term basis. It could lower your risk and boost your gains dramatically.

This long-term strategy has generated four buy signals and three sell signals over the past 20 years. You can follow it with one of two methodologies:

  1. You can buy when the buy signal occurs and sell when the sell signal occurs, at which point you will sit in cash until the next buy signal. This approach would have gained you 619.10 points over the last 20 years, compared to the S&P 500’s 317.26%.
  1. You can buy when the buy signal occurs and sell when the sell signal occurs, then take a short position. In this case you would profit from downside moves, though you’d be exposed to the risk of prices advancing. Investors taking this approach gained 900.93% over the last 20 years.

(The calculations in this article do not include investing costs, taxes or dividends.)

You’re probably wondering how on earth we could beat the market by 1.95 to 2.84 times, respectively, while reducing risk.

I’ll explain…

The black line in the chart below is the S&P 500. The green line is the 20-week exponential moving average (EMA) and the red line is the 40-week EMA.

Notice that the 20-week EMA tends to stay above the 40-week EMA during bull markets, and remains below it during bear markets.

The black arrows point to when the moving averages cross. When the 20-week EMA crosses from below to above the 40-week EMA, it’s a buy signal. When the 20-week EMA crosses from above to below the 40-week EMA, it’s a sell signal.

What I love most about this strategy is it helps investors keep a level head with the intermediate-term volatility that keeps investors wondering if this is the end of the most recent major trend.

View larger image

To be clear, you shouldn’t make decisions about individual companies based on general market signals. Even when the signal is right about the market, good companies tend to outperform the broader market… which is why we invest in companies, not markets.

Still, for those of you who enjoy trying to “beat” the general market with a market-indexed ETF like the SPDR S&P 500 (NYSE: SPY), this is a good tactic to try, provided you limit this activity to the small portion of your portfolio.

Here’s another reason you should limit this activity to a small portion of your assets: Consider how many investors lose money when they are shaken out of the market when prices are low and fear is high. And how many investors buy near the top when markets are overly positive.

And even if your timing is right, your trading costs – including commissions, slippage and taxes – will eat up much of your gains.

The shorter-term the price move is, the more random in nature it tends to be. But with a very long-term view on bull markets and bear markets, the moves are more logical, less random… and they allow for long-term tax rates.

This strategy helps investors to avoid thinking short-term and thus making short-term emotional mistakes.

Take a moment to compare the chart above to the tables below.

Version 1 assumes we simply own the S&P 500 when the 20-week EMA is above the 40-week EMA and we sit in cash when it’s not. Consider the reduction in the risk of the stock market when we are sitting in cash

With this version, we gain 619.10% while the S&P 500 gains 317.26%.

Version 2 assumes we buy the S&P 500 when the 20-week EMA moves above the 40-week EMA and then take a short position when the 20-week EMA moves below the 40-week EMA. Here the strategy gains 900.93% while the S&P 500 gains 317.26%.

But what happens when we cut out the roaring ‘90s? In version 3, we start with the sell signal on November 13, 2000. Note how the S&P 500 buy and hold strategy stays in negative territory for about 13 years (until last year) while our strategy consistently showed gains.

Using this strategy, we only saw one misstep in two decades, from August 2011 to January 2012.

The misstep resulted in a 9.80% decline.  That’s a small price to pay, considering the strategy avoided the 49% decline from 2000 – 2002 and the 57% decline from 2007 – 2009.

Good investing,

Chris Rowe

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