Back-Testing the 200-Day Moving Average
In Figure 17-2 are the daily and 200-day moving averages of the Dow
Jones Industrial Average during two select periods: from 1924 to 1936
and 1999 to 2006. The time periods when investors are out of the stock
market are shaded; otherwise, investors are fully invested in stocks.
Over the entire 120-year history of the Dow Jones average, the 200-
day moving-average strategy had its greatest triumph during the boom
and crash of the 1920s and early 1930s. Using the criteria outlined above,
investors would have bought stocks on June 27, 1924, when the Dow
was 95.33 and, with only two minor interruptions, ridden the bull mar-
ket to the top at 381.17 on September 3, 1929. Investors would have ex-
ited the market on October 19, 1929, at 323.87, 10 days before the Great
Crash. Except for a brief period in 1930, the strategy would have kept in-
vestors out of stocks through the worst bear market in history. They
would have finally reentered the market on August 6, 1932, when the
Dow was 66.56, just 25 points higher than its low.
Investors following the 200-day moving-average strategy would
also have avoided the October 19, 1987, crash, selling out on the previ-
ous Friday, October 16. However, in contrast to the 1929 crash, stocks did
not continue downward. Although the market fell 23 percent on October
19, investors would not have reentered the market until the following
June when the Dow was only about 5 percent below the exit level of Oc-
tober 16. Nonetheless, following the 200-day moving-average strategy
would have avoided October 19 and 20, traumatic days for many in-
vestors who held stocks.
The returns from the 200-day moving-average strategy and a buy-
and-hold strategy of not timing the market are summarized in Table 17-- From January 1886 through December 2006, the 10.21 percent annual
return from the timing strategy beat the annual return on the holding
strategy of 9.68 percent. As noted earlier, however, the timing strategy
had its biggest success avoiding the 1929 to 1932 crash. If that period is
excluded, the returns of the timing strategy are 43 basis points per year
behind the holding strategy, although the timing strategy has lower risk.
Moreover, if the transactions costs of implementing the timing
strategy are included in the calculations, the excess returns over the
whole period, including the 1929 to 1932 Great Crash, more than vanish.
Transactions costs include brokerage costs and bid-ask spreads, as well
as the capital gains tax incurred when stocks are sold and are assumed
to be on average half a percent when buying or selling the market. This
number probably underestimates such costs, especially in the earlier
CHAPTER 17 Technical Analysis and Investing with the Trend 297