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URL:  https://boards.fool.com/10-month-exponential-moving-average-27228225.aspx

Subject:  10-Month Exponential Moving Average Date:  11/27/2008  6:03 AM
Author:  hheiserman Number:  1610 of 1817

Earlier this week this column I wrote was published on Real Money. Doug Short, a contributor for The Motley Fool, has a fascinating site at dshort.com, if you enjoy looking at stock market behavior over the last several decades. This column also includes a chart, but I do not know how to insert a chart into the discussion board. - Hewitt


In 2000-2002 the stock market guillotined the growth investors, due to 80% declines by high-expectation names like Cisco Systems (CSCO).

In 2008, it is the value investors who are bleeding, as stalwarts like ConocoPhillips (COP) now fetch 3.4 times trailing earnings, vs. 8x several months ago.

So if both the growth and value investors are suffering, who is solvent?

The technicians, from what I can tell. These chart-reading folks do not try to ascertain how fast a company will grow in the next five years, or whether the business sells at a discount to intrinsic value. Competitive advantage and quality of management? Eh! Instead, technicians focus on price; if the stock is rising, buy; if shares are falling, sell. You can’t get much simpler than this. We are fortunate to have on RealMoney some excellent technicians, including long-time contributors like Dick Arms, James DePorre, Alan Farley, Dan Fitzpatrick, and Helene Meisler.

To learn more about my online colleagues craft, I recently spoke with Doug Short of dshort.com. Short, who has a Ph.D. in English and taught Beowulf for 15 years and later worked at IBM (IBM), built and preserved a tidy nest egg using technical analysis to maximize capital gains while protecting against severe market downturns, like what we’ve had in the last year. Here’s his story.

At one point in 2007 Short owned 40 stocks. But then as various indicators like the NYSE Summation Index deteriorated, he began selling. Then last December Short watched as the S&P 500 dropped below its 10-Month Exponential Moving Average. When the spread is negative, this is a classic “sell” signal. Short unloaded his remaining shares and went 100% cash. It was a gutsy but brilliant decision. Short preserved his family’s savings and also positioned himself to scoop up world-class companies at fire-sale prices when the market recovers.

How does this tool work? A moving average is simply the average of the last x days of closing prices, divided by x. While many investors use a 50- or 200-day timeframe, Short prefers a 10-month period, and he ignores daily closes, focusing just on the monthly closing price and its relation to the 10-month moving average. This longer period helps him catch the market’s big swings, while keeping daily noise to a minimum.

To give slightly greater weight to recent market activity, Short uses an exponential moving average (EMA), rather than a simple moving average. Your can read more about moving averages with this primer http://stockcharts.com/school/doku.php?id=chart_school:techn..., courtesy of StockCharts.com.

The chart below shows prices on the S&P 500 and its 10-month EMA from January 1995 thru yesterday. During the run-up to the market peak in 2000, the S&P (blue line) was above the trailing average (pink link) most of the time, with a notable exception during the Long-Term Capital Management crisis. In October 2000 the model said switch to cash from stocks, thereby preserving most of your capital gains.

Near the trough in 2003 the 10-month EMA said get back into stocks. The model stayed bullish for most of the time as the market staged a second rally to 1500. Then in Dec. 2007 the 10-month EMA warned you to move back into cash. At Thursday’s close of 752 the S&P is well below its 1210-level rolling average. Either the S&P must close above 1211 or the EMA must fall to 751, before this model says to stocks again.

Curious to learn whether a buy-and-hold portfolio beats a trading system based on the 10-month EMA, I created two hypothetical portfolios, each with $100,000. The first portfolio buys the S&P 500 in Jan. 1995 and then never sells. Through late last week the portfolio was worth $168,000, excluding for simplicity dividends and commissions.

Our second portfolio buys and sells the S&P 500 using the 10-month EMA as a trading signal. This portfolio grows to $310,000, even though it was in stocks just 70% of the time. Again, dividends and commissions are excluded, as is the interest received when the portfolio was in cash. Thus, for the last almost 14 years, a buy-and-sell approach walloped a buy-and-hold strategy. There are no guarantees that this strategy will work just as well over the next 14 years, however.

I asked Short if market timing works over longer periods? “Over decades, buy-and-hold vs. a monthly moving average strategy is pretty much a wash,” he says. “But if you compare betas, there's a big difference in favor of timing.”

Short emphasizes that moving averages like the version he employs are for risk management, and may not be appropriate for everyone. It won’t get you in at the bottom, or out at the top. Indeed, given the wide gap between Thursday’s close and the 10-month EMA, we may be at a market bottom. “I don't recommend moving averages to my children, who are making monthly contributions to their 401(k)’s and IRAs at these depressed prices. But for boomers in or near retirement, portfolio risk management should take priority over risky efforts to seek alpha.”

“I'm continuing to watch the 10-month indicator for a signal to move back into equities,” Short concludes. “It's by no means fool proof. In tight sideways markets, it can whipsaw you in and out of equities. But in strongly trending markets, such as we've seen since the mid-1990s, this signal has been quite effective.”

Indeed it has. Thanks, Mr. Short.
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