Market Timing using Exponential Moving Averages

Chartists and momentum investors typically look to moving averages (MA) as signals of market movement trends.  As such, even if you don't use such indicators, it is helpful to understand them as other traders certainly do pay attention to them and act on their signals.   Moving averages are lagging indicators, meaning they are used to identify pre-existing trends rather than predict future movements.  For example, when a stock price is above its 50-day MA, it is seen as being in a uptrend and many investors choose to go long in such circumstances.  On the other hand, once a price is below its MA, it is seen as being in a downtrend.

While one MA alone gives a generic sense of a price's trend, more commonly two are used in tandem.  As a short-term momentum indicator, the 12- and 26-day MAs are frequently used.  When the 12-day average is above the 26-day it is seen as a bullish phase with positive momentum going forward.  Conversely, when the 12-day passes below the 26-day, it indicates negative momentum.  These two are also used to create more complex indicators such as the Moving Average Convergence Divergence (MACD).


For example, in the above chart for Google (GOOG), the crossover of the 12-day indicator below the 26-day signals a negative trend and potential sell signal.  On the other hand, the MACD signals a slight buy (although it being in negative territory is usually seen as slightly bearish).  As you can see, different indicators can say opposite things about the same stock at the same time.  Thus, looking at just one in a vacuum doesn't seem wise as it's best to have a complete picture.  Volume is another key aspect that chartists tend to look at to see if a movement is legitimate or not.  (Note that I do not consider myself a chartist or technical analyzer.  I find it interesting and appreciate the sentiments learned by such analyses, but prefer to generally rely on fundamentals).

For long term trends, it is more appropriate to use the 50 and 200-day moving averages.  The same logic applies as the above, but these signals are much less frequent and are used to identify significant bear and bull markets.  There are two types of moving averages - simple and exponential.  While the SMA gives the same weight to all the data within the range, the EMA gives more weight to the latest data.  Thus, EMAs reacts slightly faster to price changes than their SMA counterparts.

The Strategy

An interesting market timing strategy is to use the long-term EMAs as signals to enter and exit the market as key points.  Since they're so long-term, the signals are not very frequent and it's quite simple to follow.   The purpose of such a strategy is to avoid the worst downturns while being able to maintain market positions during bullish phases.

I tested a strategy that uses the 50-, 100-, and 200-day exponential moving averages.  Using a $10,000 investment in an S&P 500 ETF (SPY), I went back to 1993 to start the backtest and went through the open on 2/16/10.  My strategy was quite simple: sell when the 50-day EMA moves below the 200-day EMA and buy when the 50-day EMA moves above the 100- or 200-day EMA.  The reason I added the 100-day for the buy signals instead of simply using the 200-day is that in extreme bear markets, the 200-day is far too long of a laggard.  Investors would then miss most of the upswing (as what would have occurred in 2009).  Plus, I think being in the market more often than not is a reasonable strategy and selling only when downward trends are clear is advisable. 

Using the above strategy, there were only six roundtrip transactions in 17 years.  That is about one buy and sell every three years.  As you can see, this doesn't require that much monitoring and keeps you in the market for the majority of the time.  I didn't calculate T-bill rates or cash equivalents when the strategy called for being out of the market, so it is inherently at a disadvantage.


Of the seven transactions (one more than previously indicated since I'm including the start and end points), two were marginal losers in the amounts of 3% and 5%.  The other five accounted for gains of 1%, 110%, 22%, 58%, and 14%.  

EMA Timing

Buy Date Buy Price Shares Cost Basis Sell Date
1/29/1993 43.94 227.58 $10,000.00 4/13/1994
8/18/1994 46.45 218.42 $10,145.65 12/9/1994
1/17/1995 47.03 209.23 $9,839.86 10/5/1998
10/30/1998 110 187.71 $20,648.43 10/18/2000
3/18/2002 116.67 216.00 $25,200.48 4/11/2002
5/1/2003 91.9 259.93 $23,887.21 1/2/2008
6/1/2009 94.77 397.50 $37,671.09 2/15/2010

Sell Price Sell Value Difference % Net Change Cumulative
44.58 $10,145.65 $145.65 1.46% 1.46%
45.05 $9,839.86 -$305.79 -3.01% -1.60%
98.69 $20,648.43 $10,808.57 109.84% 106.48%
134.25 $25,200.48 $4,552.04 22.05% 152.00%
110.59 $23,887.21 -$1,313.27 -5.21% 138.87%
144.93 $37,671.09 $13,783.88 57.70% 276.71%
108.04 $42,945.92 $5,274.83 14.00% 329.46%

Cumulative: +329% 

The S&P 500 was up 146% over the same period.  If you had invested $10,000 in 1993 and used the EMA strategy, you'd have $42,946 today, while buy-and-hold would have left you with $24,600.  Note that the above only captures capital appreciation and excludes dividends.  Thus, the gains are actually greater than stated in both circumstances.  As you can see, this timing strategy had some impressive outperformance over this period which encompassed one of the greatest bull markets of all time and two large bear markets in 2000-2002 and 2008.
Red = S&P 500 buy and hold
Blue = EMA Timing

Similar to other market timing strategies, one can plainly see that it trails buy and hold in continuous bull markets (1993 - 2000).  This is no surprise since being out of the market when it's up virtually every month never helps performance.  Despite this, since EMAs indicate past trends, there were only thee very short periods through 2000 that it indicated to be out of the market, and thus the strategy captured the majority of the gains.

Another performance figure that I like to examine to measure volatility and risk is the year-by-year values.  Of the five years in this sample range wherein the market had a negative return, the EMA strategy outperformed in four of them.  In the two worst years, the EMA considerably outperformed.  In 2002, the S&P was down 21%, while the EMA strategy called for being in the market only about a month the entire year and thus was down a mere 5%.  In the disastrous 2008, the S&P sunk 34%.  The EMA strategy signals a sell right at the beginning of the year and never got into buy territory, so it remained unchanged.  See below for the year-by-year performance with the better performing strategy in green, if applicable.

Year Buy and Hold    EMA     Strategy
1993 6.03% 6.03%
1994 -5.11% -10.22%
1995 30.22% 30.22%
1996 16.92% 16.92%
1997 23.62% 23.62%
1998 23.48% 12.29%
1999 15.20% 15.20%
2000 -5.55% -3.94%
2001 -16.04% 0%
2002 -21.43% -5.21%
2003 29.73% 21.60%
2004 6.91% 6.16%
2005 5.87% 5.87%
2006 11.29% 11.29%
2007 1.65% 1.65%
2008 -34.44% 0%
2009 37.76% 18.57%
2010 -3.85% -3.85%
  Total       +146%         +329%

On the other hand, during years the market performed very well, the EMA strategy sometimes underperformed.  There were five years of greater than 20% gains: 1995, 1997, 1998, 2003, 2009.  The EMA strategy got all the gains of '95 and '97.  It captured about half of that in '98, 2/3 of it in 2003, and half in 2009.  Since the strategy is a laggard, if the market was up in a year following a bull market, the EMA never signaled a sell and then captured all the gains.  If, however, the run-up was after a large correction as those that happened in 2000-2002 and 2008, then it took some time for the buy signal to be initiated and the EMA strategy missed some of the uptick.


As a long-term trend indicator, the 50-, 100-, and 200-day exponential moving averages do signal momentum shifts in the market.  This simple strategy had an impressive outperformance of the market during this time period, but there is certainly no guarantee that such a pattern will continue to exist.  Having said that, I think this strategy actually makes more intuitive sense than Sy Harding's Seasonal Timing Strategy (that I explored in this post) and requires very few transactions over a long period.  Its key to success is exiting the market near the relative beginning of huge downturns.  

Furthermore, this strategy is successful during periods of high volatility, while during a sideways market, it would simply signal nothing and thus is the same as buy-and-hold.  It is for that reason, that I like it more than many other timing tactics.  Instead of trying to enter and exit the market frequently at opportune times, this approach only acts when trends have been clearly established.  

Rather than taking these signals without reservation and having them dictate the complete selling of your equity position, I personally could see risking a bit less and selling about half of your equity position and investing in bonds with that half.  That way, it's a combination of a buy-and-hold and market timing strategy.  While no market timing strategy has really shown to outperform the market in all conditions over a lengthy period of time, those risk averse investors who cannot stomach large downturns might consider this simple EMA timing strategy (or simply reduce their equity percentage).

2010 Sector Outlook: XLK, XLV, XLU, and XLE

Technology, health care, utilities, and energy appear to be the sectors most poised for outperformance of the market at large in 2010. Although nobody can effectively and reliably predict the sector movements at any given time (and sector rotation strategies are a high-risk, high-reward proposition), the current macroeconomic factors at play lead me to believe that these four areas will perform well in 2010. The corresponding Select Sector SPDR ETFs are XLK, XLV, XLU, and XLE. Here is a breakdown of these four industries.


Although technology had a huge upswing in 2009 (up 54%), I still think there is room for continued upside as the valuation on a forward P/E basis is still reasonable. The close of XLK today was 20.84 - a level in the trading range of 18.3 -22 that XLK was in from the beginning of 2004 until September 2006. XLK is down about 9% YTD, making it a good entry point at this time in my mind. Although this move has been on some considerable volume, which causes me some concern as high volume often indicates that a move is legitimate. Nevertheless, I see technology as the single most important catalyst in the worldwide economy for continued recovery and growth. And I'm cautiously optimistic that we will see that growth this year. On top of that, technology typically performs well in inflationary periods, which is what many expect us to see in the next year or two. With its top holdings as Microsoft (MSFT), Apple (AAPL), IBM, AT&T (T), Cisco (CSCO), and Google (GOOG), technology has some major innovators and stalwarts that are key for our economic well-being. And with forward P/Es averaging about 13.5 versus a current P/E for the market at large at 16.2, they seem to be a bit undervalued.

The are, however, many negatives. For one, it seems like most pundits and investors are extremely bullish on tech and this oftentimes serves as a contrarian indicator. Likewise, in typical stock market cycles, technology leads the way at the beginning of the bull market, but only modestly outperforms six months after the recession. From a technical perspective, as you can see in the chart below, the MACD signal is showing "sell" with both the EMA-26 and EMA-9 in negative territory, often also seen as a bearish sign. In addition, the 20-day moving average just pierced through the 50-day moving average from the top (on fairly high volume as I stated earlier), which also signals a "sell." If I was going only by the technical analysis, I would be a complete bear on tech. However, I prefer to analyze the fundamentals and use that to dictate my investment choices. I am certainly not a chartist or momentum trader, although I like to point the technicals out to those who find it intriguing. Ned Davis research also points to the fact that the breadth is weakening, the seasonality trade has ended, and that production from a factory perspective for high-tech machinery remains quite weak.

Despite all these negatives, the valuation of the sector and ability of the aforementioned companies to spark an economic rally and innovation war with one another, leads me to think that XLK will be a good sector to own during 2010. Tech is always a fairly volatile industry, though, so it's certainly not for the faint of heart and is a bit riskier of a proposition than perhaps other options. (Disclosure: I picked up some XLK today, 2/4/10 with a limit order at 20.94.  Sold it on 5/11/10 at 22.93 for about a 10% gain in a bit over two months).

Health Care

This sector will benefit from increased inflation and an aging population in the upcoming year. Although the one trump card in this sector is certainly any changes coming out of Washington, which may affect the profitability of certain areas. But such a proposal out of Congress seems unlikely at this point based on what has been passed and the proposals currently floating around that have ample support. Another pause for concern is the ending of patents for several major blockbuster drugs in the next couple years. The points that make this sector really attractive to me is its defensive nature in times of economic uncertainty, its undervaluation on an absolute basis compared to all other nine sectors (per Ned Davis Research), its ability to deliver sizable dividend yields, and the amount of cash on hand. XLV's top holdings include Johnson and Johnson (JNJ), Pfizer (PFE), Abbott Labs (ABT), Merck (MRK), Amgen (AMGN), and Bristol-Myers Squibb (BMY).

XLV is flat YTD and was up about 20% in 2009. It's 20-day MA is still above the 50-day MA signaling a bullish phase (although it's teetering), while the MACD that is a shorter-term indicator is in a slightly bearish. Not too much to glean from the technical chart, but the fundamentals to me signal a buy. XLV closed at 30.88 today.


Utilities as a sector is quite often defensive and boring; but that is why I like it. Its volatility isn't that great and many of the companies offer solid dividends. The demand for utilities will probably remain relatively weak given the state of the housing market, but with energy prices likely increasing and investors seeking undervalued, dividend-oriented plays, I think utilities and XLU is a solid bet for 2010. They only returned about 10% in 2009 and are down about 7% YTD, but I really expect them to be an attractive place for many risk-averse investors.

Standard & Poor's and Ned Davis Research appear to be more negative on this sector that I am, though, so I certainly will admit it if I made a wrong call. S&P argues that "an ongoing domestic economic recovery will continue to fuel cyclical outperformance at the expense of this counter-cyclical sector" which is certainly a valid stance. Utilities tend to perform best in the middle of a stock market bear, certainly not after a large upswing in the market. However, going by this same logic one would be inclined to snatch up consumer discretionary names, and I think our economic experiences in the past two years and the continued poor employment market are going to lead to a scared consumers. They certainly can sacrifice luxuries, but will continue to live and pay utility costs. Similar to S&P, NDR has a list of sector negatives such as "long-term overbought conditions," "excess capacity," "low beta," and "weaker pricing becoming a concern." However, they still have it at marketweight based on shrinking credit spreads despite the fact that valuations suggest they're not at bargain prices anymore. From a technical perspective, the signals and money flow are in a bearish phase. This sector, along with tech, are my two riskier picks.

Commodities, and oil in particular, have had a rough couple weeks, but since I believe the global bull market will continue, I have to think that oil has some upside. Crude oil supplies are relatively high from a historical perspective, but it appears that energy is going to prove vital in many of the infrastructure projects being targeted by various governments. Emerging markets certainly will have increased demand for energy in the upcoming years (and demand in the US should have an uptick with the improved economy) and as a group, the names in the energy field are trading a bit under their valuation. The MA indicators are in the bullish phase, while the MACD is bearing as is the 3-day cash flow. XLE's largest holdings include ExxonMobil (XOM), Chevron (CVX), Schlumberger (SLB), ConocoPhillips (COP), and Occidental (OXY).

(Update 4/27/10: I would no longer own the energy sector as a result of the BP oil spill that was reported in the last few days.  As new information comes and situations change, it's important to be flexible with your investments.  You can't marry any particular position and when something disastrous like an oil spill occurs, that certainly makes the sector a huge question mark in the short-term.  I personally don't feel that the risk is appropriate to take on and would close my position.   This could be bad...really bad.  So, I'd get out personally.)


In the end, we'll see at the end of this year if these were good picks or not. Certainly, I re-assess as market conditions and macroeconomic factors at play change (as they undoubtedly will), but I think these four are a good starting point and I will happily admit it if I am off-base. It will be interesting to see how these perform. On a separate note, what would I avoid in 2010? Treasuries. Gold also seems set for a pull-back after a monstrous 2009, even if that's contradictory to my above statements regarding inflation.

As I have said in previous posts, I don't think market/sector speculation and investing in non-diversified offerings is the way to go for the vast majority of investors. However, I think it's reasonable to make some gambles (and yes, they're educated gambles) with 5-10% of your assets if you have the necessary time and knowledge, and enjoy performing such trades.

Here are the closing prices as of 2/4/10 for the four aforementioned ETFs as well as a S&P 500 Index Fund. Performance will be updated sporadically and compared to the return of the S&P at large:

XLK: 20.84
XLV: 30.88
XLU: 28.99
XLE: 54.29
SPY: 106.44

Updated Performance:
Sector Start Price Current Price Change Through
XLK 20.84 25.19 +20.9% Year end
XLV 30.88 31.50 +2.0% Year end
XLU 28.99 31.34 +8.1% Year end
XLE 54.29 68.25 +25.7% Year end
S&P 500 106.44 125.75 +18.1% Year end

This further illustrates how hard it is to predict sectors.  The cumulative average of the four sectors was +14.2%.  However, this doesn't include dividends.  I really should like them up to make the comparison truly valid but don't have time right now.

Fidelity Strikes Back! Reduces Commisions to $7.95 and Offering Free Trading on 25 iShares ETFs

Well, that didn't take long. Fidelity Investments slashed its commissions for trading to $7.95 for all customers and is now offering 25 extremely popular iShares ETFs without trading fees. This is clearly in response to Schwab's similar announcements in December. The increased competition and offerings are really a positive occurrence for investors and I certainly welcome the changes.

The free ETF portfolio spans all the necessary asset classes to create a low-cost diversified portfolio - from small-cap value in US equities to international emerging markets to many fixed income such as the aggregate bond index, TIPS, muni bonds, and investment grade bonds. The ETFs are much more extensive than the commission-free ones from Schwab. Not only that, but since they are the BlackRock iShares products instead of the brokerage's own product (as Schwab did), they have very high volumes and a much larger pool of assets, which typically leads to smaller bid-ask spreads. On the other hand, many of the iShares ETFs' expense ratios are higher than the Vanguard and Schwab equivalents. For example, the Emerging Markets ETF clocks in at 0.72%, while VWO is 0.27% for essentially the same product. In the end, though, the difference is fairly negligible for most of the ETFs so shouldn't be a grave concern.

Here's a screenshot from Fidelity's website of the various ETFs offered sorted by category:

It doesn't say how long the offer is going to last, but I'd expect the reduced commissions will be for quite some time or else there would be some serious backlash. Another website is reporting the free trading for the iShares ETFs will be for "at least three years."

This is great news for the owners of more than 12 million Fidelity brokerage accounts. Kathleen A. Murphy, president of Personal Investing at Fidelity, released a statement:
Fidelity has partnered with the leading ETF provider in the market to bring investors the best brokerage offering in the industry today. Simply put, we’re offering the broadest selection of commission-free ETFs from the undisputed ETF leader, and it’s only available through Fidelity. When you combine this new initiative with the fact that Fidelity offers the largest funds supermarket in the industry, sophisticated online investment planning tools and extensive, institutional-grade stock research, you can see our relentless focus on providing every advantage to Fidelity customers so they can be more successful investors in today’s fast-paced and fluid market environment.

Michael Latham, Head of US iShares, BlackRock, expressed his excitement about the agreement:
We’re very excited that Fidelity, a proven leader in the retail brokerage industry, is promoting ETFs and furthering iShares availability to investors. The 25 iShares Funds that Fidelity chose to include in this offering represent leading indices in each asset class and can be used as the foundation for building an investor’s portfolio. Fidelity is strongly committed to investors, and their decision to offer iShares is a great validation of ETFs as a mainstream investment.

In any event, now it's even easier to create a great portfolio with Fidelity and these ETFs are great indexed, low-cost, high-volume ones to choose. My post that I wrote 10 days ago, "Comparison of Vanguard, Schwab, and Fidelity Fund and ETF Offerings," needs an update already! I used many iShares ETFs for the "alternate" column, though, so clearly you can tell I hold them in high esteem. In the end, there is really no excuse to pay exorbitant fees with any broker. They all have ample offerings with low-costs such that investors can easily create a complete portfolio with an appropriate asset allocation for their age, risk, and objectives. The increased competitive, low-cost, diversified offers from various brokerage houses is certainly a welcome development in the brokerage landscape.
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