100 Year! - Back Test Study
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Hi all, for anyone that trades or invests in the financial markets this could be one of the most beneficial videos to date. This equity curve runs from 1960 through to 2020, turning a 100,000 investment into over 5 million, but perhaps more importantly, with controlled drawdown. The strategy is backed by research and is so simple that its easy to dismiss, proving that complexity is not always the answer. The research study was completed by Meb Faber in 2013 and is a core strategy piece of billionaire trader Paul Tudor Jones.
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The approach in today’s video is based on the largest 500 companies in the US, meaning that neither liquidity nor scalability are concerns.
The strategy is proven by back tests based on two different rules, the first back test is based on the 200-day moving average rule. The rule is simple, buy the S and P 500 index when price crosses above the 200-day moving average, and sell the position when price crosses back down below the 200-day moving average. It’s simplicity falls into the category of “if it was that simple then everybody would be doing it” which is precisely why many dismiss the idea. The results however are undeniable, the equity curve from 1960 shows a rather linear increase throughout the decades, whilst many of the major market crashes were avoided, with the great financial crash of 2008 being the largest of most recent times.
Let’s look at the 200-day moving average rule in action during the great financial crash.
The red line represents the average price of the S and P 500 index from the previous 200 days. We can see that in late 2007 prices crossed below and crossed back above the moving average on numerous occasions, leading us to exit and enter our positions accordingly. The frequency of trades would have led to some small losses, but this last exit saved us from a huge drawdown thereafter, when price dropped more than 50% over a 17-month bear market. These periods of decline are shown as a flat line on our equity curve and represent periods where we would have been in a cash position only.
It’s essentially a mechanical trend following system which limits risk and removes emotion from decision making. The strategy can however be improved upon further, this time replacing the 200-day moving average rule with the 10-month moving average. We exit the index and remain in cash when price closes below the 10-month moving average, and only re-enter when price closes back over the moving average. Once again we would have almost entirely eliminated the major declines from the dot com collapse in 2000, and the great financial crash a few years later in 2008. But which method is best, the 200-day moving average or the 10-month moving average?
We can directly compare both moving average strategies by aligning the equity charts together. Here we have the previous 200 day moving average strategy, and if we overlay the 10-month moving average strategy we can see that both reach a similar end point, although if I were picky I prefer the more consistent trajectory of the 10-month rule rather than the 200-day rule. The 10-month rule was analysed in detail from the Fama study and will be used for analysis throughout the next part of the video.
The study was tracked all the way back to the nineteen hundreds, with comparison made between the 10 Month moving average rule and a buy and hold approach. $100 dollars invested in the year 1900 would have compounded to a return of just over 2 million, whereas $100 invested with the 10-month timing approach would have turned into just over 5 million. The key however is not the end point value but the journey getting there. The buy and hold approach had a volatility percentage of 17.87 enduring many declines, whereas the timing approach saw volatility of 11.97%, avoiding many of the major declines. A closer look at the dot com bubble and the great financial crash shows just how beneficial the timing approach is.
One thing to mention here is that when in a cash position it is assumed that we achieved an interest rate aligned to a 90-day treasury bill, hence why there is a slight increase in these cash position areas.
Let’s look at the worst 10 years for the S and P throughout the 110 years and compare against the 10-month timing approach. Starting with the worst year in 1931 which had a loss of over 43%, through to the tenth worst year in 1973 at a loss of almost 15%. Seeing these losses in your portfolio would have been difficult to manage emotionally, yet if we used the timing model of only being invested in the S and P when prices were above the 10-month moving average, we would have been in far better emotional state. The average worst year for the S and P equalled just under a 28% decline, whereas the 10-month timing approach lost an average of 2.2% over the same period. The great financial crash we just touched on, saw the buy and hold investors lose more than 36% of their portfolios during that calendar year, whereas the 10-month timing model remarkably made a positive return.
Before we bring the study up to date to include the pandemic and the global market decline seen in 2022, it’s worth mentioning now that the approach does not just serve as a stand-alone strategy (although it could), but it could be used as a foundation for all your strategies in the stock market. Whether you’re a longer-term fundamentalist, or a medium-term breakout trader like myself, simply adding the 10-month rule could change everything.
Bringing the approach up to more recent times, lets first look at the pandemic. The peak of the S and P 500 index was seen in February, just as the pandemic took centre stage. The bottom of the market came in March before recovering to new highs over the following months. The 10-month moving average rule marked by this red line, would have seen us exit here at the candle close, just before the huge March decline. We would have re-entered here at the candle close, above the 10-month moving average. By applying the tactic we would have largely avoided the drawdown and volatility, and re-entered at a marginal variance to the prior exit.
Price continued its recovery whilst remaining above the moving average line, all the way through to 2022. The first-time price closed below the 10-month moving average line was here in February 2022, although we re-entered the following month after price closed above, only to exit again the following month after a close of a large negative candle. We stayed out of the market the following six months as price remained volatile below the moving average line, before entering and exiting again in a two-month period. Time will tell if the 10-month rule works beyond this point, although history going back more than 100 years says it will.
How about other stocks or funds beyond the S and P 500? Well, lets look at Cathie Wood’s popular flag ship fund; Ark Innovation. We can see that price remained above the 10-month moving average, capturing most of the gains in the uptrend.
We would have made an exit and re-entry here, whilst our final exit would have been here when price closed below the line, saving a further loss of almost 75% to date.
How about Jeff Bezos’s Amazon?.... We can see that from 2015 through to the end of 2019 price remained above the 10-month moving average, In fact, the beginning of 2015 saw a breakout of consolidation rising from just under 18 dollars per share, through to 80 dollars per share when price closed below the 10 month moving average line. Several trades would have occurred over the next 4 years, but the timing of the final exit could not have been timed any better, price closed below the 10-month moving average here, saving more than a 50% drop in price.
Clearly not every single stock example would have worked equally as well, but we can certainly see how the approach works in principle.
If we look back at the study using the S and P 500, we can see that since the 1900’s there is a positive bias to the right-hand side, showing that there are more occurrences of a positive annual return above zero than there are of returns below zero, this explains the upward trajectory of the S & P in the long term. If we now add the 10-month moving average rule to the chart, we can see there have been no annual losses greater than 30%, although there were fewer annual gains greater than 30%. Overall the timing approach gave a greater positive bias than a simple buy and hold approach, whilst limiting drawdown.
The beauty of the strategy is many fold, it’s a mechanical system that removes emotion, it reduces drawdown significantly, and is used on a diversified index covering 500 of the largest companies in the US, constantly churning out poor performing stocks and replacing with new. As a standalone approach it has shown remarkable consistency for over a century and could certainly be considered as a foundation for any approach.
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