Most of standard technical analysis is just “reading the tea leaves”, hence why many technicians can’t even beat buy and hold in the stock market. That’s why fundamental (economic) analysis is more important than technical analysis, as we’ve shown through these quantitative trading models.
In today’s post we’re going to be looking at why the 200 day moving average isn’t as important as standard trading “wisdom” would have you believe.
The 200 day moving average is regarded by many technicians as the “make it or break it” line. If the stock market is above its 200 day moving average, then it’s “bullish”. If the stock market is below its 200 day moving average, then it’s “bearish”.
Sometimes the 200 day moving average is useful as support or resistance. But the 200 dma represents one of the biggest problems with technical analysis. For every 1 time it does work, there are 2 times it doesn’t work. In other words, technical analysis gives you too many false signals that causes you to underperform buy and hold.
The following chart is the S&P 500 right now. The S&P has been “saved” on its 200 daily moving average. Hence chart watchers would believe that the 200 daily moving average is useful.
Except when you look back at history, the 200 day moving average has more false signals than it has useful signals. The following chart demonstrates the 200 daily moving average’s many false SELL signals from 2014-2016.
Here’s the fact: there’s nothing special about the 200 day moving average. It isn’t much different from the 198 dma, the 199 dma, the 201 dma, the 202 dma, the 203 dma, the 204 dma, etc. Traders use it solely because other traders are using it. And as we all know, doing something just because other people are doing it is generally not a good idea.
Here’s more proof that the 200 daily moving average (or any moving average for that matter) isn’t an extremely useful indicator.
If the 200 daily moving average were useful, buying when the S&P is above its 200 dma and selling when the S&P is below its 200 dma would outperform buy and hold. If this strategy (buy above the 200 dma, sell below the 200 dma) underperforms buy and hold, then it proves that the 200 dma isn’t a very useful indicator.
Remember: if a strategy, model, or indicator can’t even beat brain-dead buy and hold, then it doesn’t have much value.
The facts: backtested
If you buy and hold the S&P 500 over the past 30 years (1988 – present), you would have earned an average annual return of 8.09%
If you bought when the S&P was above its 200 dma and switched into cash when the S&P was below its 200 dma, you would have earned an average annual return of 6.56% over the past 30 years.
Click here to download the data in Excel.
In other words, using the 200 dma to trade causes you to underperform buy and hold.
And top it off, traders face higher tax rates than long term investors. So after factoring in higher taxes, traders who use the 200 dma to trade MASSIVELY underperform buy and hold.
Some traders say “that’s why you should wait for the S&P to break below its 200 daily moving average for X number of days”. I’ve tried various combinations, and none of them improve the results from using the 200 dma. It doesn’t matter if you wait 3 days, 4 days, or 5 days after the S&P breaks below its 200 dma before selling. The results are pretty much the same. Using the 200 dma in all of these ways underperforms buy and hold.
Standard technical analysis gives TOO MANY false signals. That’s why you must combine technical analysis with fundamental analysis in your trading models/strategies.
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