StockWatch

Good Enough

By Mark Hulbert,
Editor of the Hulbert Financial Digest, a service of MarketWatch.com

It was Voltaire who famously said that the perfect is the enemy of the good.

And, though he wasn't talking about investing, he very well could have been: The relentless pursuit of a "perfect" market timing system can lead to an inferior result.

Take market timers who rely on the 200-day moving average to determine whether they should be in or out of the stock market. It, by no means, is a perfect system as I'll discuss in a moment. But, by the same token, it has proven difficult -- in practice -- to do better.

Though trend-following systems have a long history, I suspect that the popularity of the 200-day moving average in recent decades can be traced largely to Richard Fabian, who, during the 1970s, began championing a 39-week moving average (virtually the same as a 200-day moving average).

Fabian, at the time, was editor of the Telephone Switch Letter, an advisory service that, since then, has gone through several metamorphoses and is now edited by his son, Douglas Fabian, and called Doug Fabian's Successful Investing.

Fabian, the elder, told subscribers that they need not spend more than a minute a week determining whether they should be in stock mutual funds or cash. If the market was above its average level of the previous 39 weeks, they should be in the market --and otherwise in cash.

Compared to almost all other market timing systems I monitor, this one was the simplest. And, yet, it also turned out to perform quite well: For the decade of the 1980s, for example, it was the very best performer of any tracked by the Hulbert Financial Digest.

Still, the approach was (and is) not perfect, and Fabian was one of the first to say so. He often said, for example, that a 52-week moving average system would produce long-term returns that were far superior to the 39-week system. He, nevertheless, stuck with the 39-week average because he believed that investors would not be willing to sit out the intermediate-term declines that a longer-term moving average would require.

Researchers in recent years have raised even more serious theoretical questions about this market timing system. One was that its market-beating potential appeared, by the late 1990s, to have become greatly diminished, leading some to speculate that the veritable golden-egg-laying goose had been killed by too many investors trying to follow the 200-day moving average.

Another chink in the 200-day moving average's armor is the argument, advanced by Ned Davis of Ned Davis Research, that the approach works primarily during secular (long-term) bull markets. One of the hallmarks of cyclical (shorter-term) bull markets, according to Davis, is that, during them, trend-following systems tend not to work.

Given these apparent defects, you might think that doing better than the 200-day moving average would have been relatively easy, especially in recent years. But, it hasn't been.

We know because Fabian, the younger, has been trying to improve on it, almost from the point he took over the advisory service from his father in the early 1990s. On balance, his deviations from the mechanical 39-week moving average system have cost his model portfolio.

Consider, for example, a hypothetical portfolio that mechanically followed Fabian's 39-week moving average system to switch between the Wilshire 5000 index and 90-day T-Bills. According to the Hulbert Financial Digest, such a portfolio would have produced a 3.0 percent annualized return over the last five years.

Fabian's model portfolio, in contrast, produced a 1.4 percent annualized return over the same period.

What does the 200-day moving average market timing system say about stocks, currently? It says we should be fully invested because the market is comfortably above its average level of the last 200 days. In fact, the market remained above that average even at the bottom of its January - February correction, and subsequent market strength appears to be increasingly vindicating its decision to remain bullish.

Perhaps not a perfect answer about what stock investors ought to currently be doing -- but, maybe, good enough.