The S&P 500 closed the month of January 3.7% below the December close. However,all three of the S&P 500 monthly moving averages we've been tracking continue to favor equities.

Since 1950 the S&P 500 10-month SMA has had 41 buy signals; 26 of them (63.4%) led to a gain before the next sell signal, 15 of them (36.6%) led to a loss. The 12-month SMA has had 31 buy signals, 21 (67.7%) led to a gain before the next sell signal, 10 (32.3%) led to a loss. These moving-average signals have a good track record for long-term gains while avoiding major losses. But they're not fool-proof.

Note: I've also update the Stockcharts.com charts for the five ETFs in the Ivy Portfolio. You can always click the Ivy Portfolio link in the left column for the most recent month-end charts with 10- and 12-month SMAs. Bonus Feature: For anyone who would like to see the 10- and 12-month simple moving averages and the equity-versus-cash positions since 1950, here's an Excel file (xls format) of the data. My source for the monthly closes (Column B) is Yahoo! Finance. Columns D and F shows the positions signaled by the month-end close for the two SMA strategies.

Background on Moving Averages

Buying and selling based on a moving average of monthly closes can be an effective strategy for managing the risk of severe loss from major bear markets. In essence, when the monthly close of the index is above the moving average value, you hold the index. When the index closes below, you move to cash. The disadvantage is that it never gets you out at the precise top or back in at the very bottom. Also, it can produce the occasional whipsaw (short-term buy or sell signal).

Nevertheless, a chart of the S&P 500 monthly closes since 1995 shows that a 10- or 12-month simple moving average (SMA) strategy would have insured participation in most of the upside price movement while dramatically reducing losses.

The 10-month exponential moving average (EMA) is a slight variant on the simple moving average. This version mathematically increases the weighting of newer data in the 10-month sequence. Since 1995 it has produced fewer whipsaws than the equivalent simple moving average, although it was a month slower to signal a sell after these two market tops.

A look back at the 10- and 12-month moving averages in the Dow during the Crash of 1929 and Great Depression shows the effectiveness of these strategies during those dangerous times.

For an interesting article on trend signals using a crossover of two moving averages, see this article on Quantitative Chart Screening for Trends by Richard Shaw of the QVM Group. The 52-week/26-week crossover looks especially interesting for long-term investors willing to check their holdings weekly.

The Psychology of Momentum Signals

Timing works because of a basic human trait. People imitate successful behavior. When they hear of others making money in the market, they buy in. Eventually the trend reverses. It may be merely the normal expansions and contractions of the business cycle. Sometimes the cause is more dramatic — an asset bubble, a major war, a pandemic, or an unexpected financial shock. When the trend reverses, successful investors sell early. The imitation of success gradually turns the previous buying momentum into selling momentum.

Implementing the Strategy

Our illustrations from the S&P 500 are just that — illustrations. In actual practice, you should have a separate signal for each asset class that you plan to use for this strategy. For example, you wouldn't buy and sell a small cap index mutual fund or ETF based on an S&P 500 signal. The strategy is most effective in a tax-advantaged account with a low-cost brokerage service. You want the gains for youself, not your broker or your Uncle Sam.

Recommended Reading

In the past we've recommended Mebane Faber's thoughtful article A Quantitative Approach to Tactical Asset Allocation. The article has now been updated and expanded as Part Three: Active Management his book The Ivy Portfolio, coauthored with Eric Richardson. This is a "must read" for anyone contemplating the use of a timing signal for investment decisions.

The book analyzes the application of moving averages the S&P 500 and four additional asset classes: the Morgan Stanley Capital International EAFE Index (MSCI EAFE), Goldman Sachs Commodity Index (GSCI), National Association of Real Estate Investment Trusts Index (NAREIT), and United States government 10-year Treasury bonds.

As a regular feature of this website, I try to update the signals at the end of each month. However, my retirement flexibility and life's unpredictability preclude a firm commitment.