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Earlier this week I reviewed Japan's historic equity bubble in comparison to the US market, and I posted a daily chart of the Nikkei 225 showing the metrics of the post-bubble rallies and declines.
Now let's now use our Nikkei 225 data to back-test some monthly moving average strategies versus buy-and-hold (B&H). This is a purely hypothetical exercise, but it may cast some light on the larger context of monthly moving averages to supplement my monthly timing update for the S&P 500 and the Ivy Portfolio.
First a word about the approach used to generate the bar charts below. I've used two sources for monthly close data: Yahoo Finance for the numbers since 1984 and Wren Investment Advisers for the earlier years. Since I don't have the Nikkei dividend yields and don't include interest on cash, the charts below understate actual returns. And I do not factor in trading costs, which will impact SMAs, especially the shorter ones. However, the comparisons should still be reasonable approximations for our purpose of comparing B&H and active management with monthly simple moving averages (SMAs).
The first chart is a reminder of what we've seen in the earlier articles — the classic shape of a major asset bubble across four decades. The peak on December 29, 1989 is almost dead center of the chart, with 20 years each of secular bull and bear markets.
Now let's compare the nominal value of an investment (no inflation adjustment) of B&H and 14 different monthly SMAs. The unit of value I've used is the dollar, but since our illustration is nominal and doesn't consider currency valuation, the choice of a dollar is simply an arbitrary unit of measure.
Across our forty-year timeline, all the SMA strategies beat B&H except the 2-month SMA, and the 3-month SMA would probably lose a real competition with B&H because of transaction costs. The top-performing 13-month SMA return is about 290% higher than B&H.
Now let's split the first bar chart into its two halves. First up is the secular bull market from 1970 to the close of 1989. Anyone who has studied monthly moving averages knows they generally underperform in a bull market, as this chart illustrates. B&H outperforms the best SMA (13-month) by about 38%.
The bear half shows the opposite result. Here every SMA handily beats B&H, with the 6- and 7-month SMAs giving the best results. The 6-month tops B&H by 528%.
Some Conclusions
To paraphrase my opening remarks, this is a thought experiment, one that back-tests some moving average strategies against buy-and-hold in a hypothetical environment based on authentic, but partial, data — monthly closes excluding dividends and interest on cash. Naturally it would be foolish to cherry-pick a monthly SMA strategy based on this data, intriguing as the results may be.
What we can conclude is that in epic secular bull and bear markets, passive management (B&H) is a successful strategy on the way up and a disaster on the way down. The reverse is true for active management with SMAs. You've got to be pretty savvy to hold your own on the way up, but outperformance on the way down is a virtual guarantee.
Of course it's impossible to pin-point those secular tops and bottoms. But one thing is very clear in our chart of the Nikkei: Cyclical volatility is minimal in epic bull markets and savage in secular bear markets.
Let's finish off with a snapshot of a Nikkei-S&P 500 overlay using the S&P 2000 high.
The US is not Japan, and time-shifting also reduces the broader economic parallels. But a couple of things are clear:
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