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S&P 500 20-Month Moving Average Strategy

In the majority of my investment accounts I employ a momentum investing approach, which enters individual equities at new 3-month highs. For my main RRSP account, I prefer a more passive approach and have designed a system that requires much less work. My strategy simply trades the S&P 500 ETF SPY long or short using only monthly closing bars. The goal of this strategy is to outperform a buy-and-hold approach with just a little more work. I believe the 20-month moving average to be the “line in the sand” for bull and bear markets so I use it accordingly. My system is therefore designed around the 20-month moving average, and relies on this indicator for future market direction.

The below images show my current accounts, which are traded by entering long positions on equities if they make new 3-month highs. The system discussed in this article is currently long the S&P 500 from 2056.62 per my April article. My S&P 500 position was entered using UPRO on April 1st and went long at 62.12. The position is currently up over 18% and has an exit price on any monthly close below 2054 on the S&P 500.

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The Strategy

My 20-month moving average strategy is not interested in catching every tick, but instead profiting from the big swings. While many investors are obsessed with trying to call bottoms and tops, I am much more concerned with finding a way to profit off all of the meat in the middle. The strategy is a trend following approach and for this reason often experiences whipsaws. These whipsaws are a small price to pay for the large moves the strategy catches. This is because the strategy follows the dominant trend of the market and never stays wrong. The strategy buys the S&P 500 when it closes the month for the first time above it’s 20-month moving average, and exits the position on a monthly close below the 20-month moving average. This strategy requires no opinions, no fundamentals and no other technical indicators. Due to the simplicity of this system, the application of it requires less than one hour of work each month. The system has no use for intraday data which allows investors the freedom of not having to watch their screen during market hours.

Short positions are entered only if the S&P 500 trades above its 20-month moving average for at least 2 years before closing below it. In the event of this occurring, the strategy exits its long position on the 1st day of the new month and immediately enters a short position on the market.

Long Entries

Long positions on the S&P 500 are opened on the first monthly close above the market’s 20-month moving average. I invest 100% of my portfolio as I want full leveraged when I believe the odds are in my favor. To get more bang for my buck, I enter UPRO once the S&P 500 gives a long signal. The strategy never exits a long position unless the market closes the month below its 20-month moving average. The most recent long signal was on March 31st of this year when the S&P 500 closed back above its 20-month moving average. The long entry of 2056.62 on the S&P 500 coincided with a 62.12 entry on UPRO. The below chart shows the March 31st signal on the S&P 500 when the market closed above its 20-month moving average. Traders using this strategy would enter a long position on the S&P 500 on April 1st at 2056.62, by buying either SPY or UPRO depending on their desired risk and leverage.

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Long trades are much more prevalent than short trades since 1970, with 15 long trades and only 6 short trades. They also have a much higher win rate than shorts, with 78% of long positions over the past 43 years being profitable. The higher win rate can likely be attributed to two things. The first is that the market has been in a long term uptrend for the past 40 years. The second reason is likely due to the fact that short trades are often whipsaws in consolidation periods for the market. In total, the strategy saw 14 long trades since 1970, 11 of these trades were winners with an average return of 38.27%. The 3 remaining trades were losers with an average loss of 3.28%. These statistics are evidence of how the strategy cuts its losing positions quickly and maximizes its winning trades. The goal of the strategy is to never stay wrong and to stay the course as long as the dominant trend is in tact.

The below image is an example of a past long trade which was opened in September of 1984 and closed in November of 1987.

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Short Entries

Short entries on the S&P 500 are only taken if the market has been above its 20-month moving average for at least 2 years, and then closes the month below it. The system was designed this way to prevent getting whipsawed too much, and to prevent taking multiple short entries during consolidation periods for the S&P 500. Unlike the long strategy, the short strategy enters short positions on any monthly close above the 10-month exponential moving average.

Short trades are much more rare than long trades, with only 6 short trades in the past 43 years. Short trades also have a much lower win rate than long trades, with only a 50% win rate. This 50% win rate for short trades is not a problem in terms of profitability. Despite the short strategy is only right half of the time, it makes up for it with massive outperformance on its winning trades vs. its losers. The average winning short trade has a gain of 27.66%, while the average losing short trade has an average loss of 5.69%.

Below is an example of a short trade taken at the beginning of the 2000 bear market and covered on May 1, 2003.

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Performance vs. Buy & Hold: 1970-Present

The 20-month moving average system for the S&P 500 has nearly doubled the performance of a simple buy and hold strategy over the past 46 years. The S&P 500 has seen a 2000% increase since 1973 from 106.70 to 2140. This means that buy and hold investors who placed $10,000 in the market in 1973 would have roughly $200,000 as of today. Meanwhile the 20-month moving average system would have seen a 3600% increase turning that same $10,000 into $362,000.

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Critics of this system may suggest that the buy and hold strategy would beat the 20-month moving average strategy when accounting for dividends. I disagree with this completely as the 20-month moving average strategy was long the market for over 32 of the past 43 years. This means that this strategy collected over 74% of the dividends that a buy and hold strategy would have collected. While this may offset the final values slightly, it cannot account for nearly double the performance by the 20-month moving average strategy.

Summary

The 20-month moving average is an effective way of reducing drawdowns and increasing performance with a fraction more work than a simple buy and hold strategy. The strategy has clearly outperformed the S&P 500 for the past 43 years and should continue to do so in the long term. The average winning trade for the strategy saw a gain of 36.01%, while the average losing trade saw a loss of 4.49%. The total win ratio for the strategy over 20 trades is 70% which is exceptional for a strategy with such a massive outperformance of winners to losers. These statistics are further evidence that momentum investing is better than a simple buy and hold approach and is certainly not dead.

The strategy requires little work, outperforms the general market and is not subject to even half of the drawdowns. The strategy also requires much less psychological fortitude as it missed the 2000 and 2007 bear markets. Instead of being long as buy and hold investors would have been, the strategy was busy profiting from the bear market before flipping back long once the dust settled. I believe the 20-month moving average strategy to be a great strategy for those with a passive investing approach. While I believe specific equities provide higher returns, those that are more interested in buying ETFs or indexes will likely find higher returns using a momentum approach such as the 20-month moving average system.

Disclosure: I am/we are long UPRO, SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: If you liked this article and found it useful, please feel free to follow me by clicking on my name next to my avatar at the top of this article. I also invite you to check my performance at TipRanks.com where I am ranked in the Top 100 Contributors for performance with an average return this year of 60% on new long positions.