The S&P 500 just broke below its moving averages. Here's why that matters.

Last week, I wrote about AIM breaking below its moving averages and what that meant for UK small-cap investors. Now it's happened to the world's most followed equity index - the S&P 500.  This holds even more significant ramifications for global investors.

The 200-day moving average is the line in the sand that almost all trend followers and institutional investors watch. When the S&P crosses below it, the character of the market changes. As Paul Tudor Jones, the great hedge fund manager, once said “nothing good happens below the 200 day moving average”.  

So this weekend, I decided to analyse 56 years of S&P 500 history to quantify exactly what we’re facing.

Two very different markets

The S&P 500 has returned +8.1% annualised since 1970, which is an impressive record. But within that number lie two very different regimes.

When the price of the index moves below its 200 day moving average, the numbers are stark. Admittedly, the performance difference between bullish and bearish regimes isn't as dramatic as AIM's 43 percentage points - the S&P 500 being a far superior collection of companies. But a 5.6% spread over half a century is certainly not noise. 

Below the 200 day MA, returns are more than halved, while index volatility nearly doubles. You are paid less for more risk, and crash risk is heightened.  The S&P 500 moved into this regime 2 days ago. The chart below shows how most of the worst breaks down in the index happen during these periods. 

Avoiding drawdowns really matters

It’s drawdowns that bring the most pain in investing. We all get anchored onto our portfolio valuation at a market peak, and we rue and regret every day we spend below it.

Consider this - an S&P 500 buy-and-hold investor would have endured a -57% drawdown during the 2007-2009 financial crisis - more than half their portfolio gone. Compare an investor who simply stepped aside when the index fell below its 200-day MA? Their worst loss across 50 years of history would have only been -28%. 

Keeping losses small is an essential skill to develop in investing. Managing drawdown depth can mean the difference between a portfolio that recovers in a year and one that takes five years to get back to even. It can also mean the difference between staying the course versus panic-selling at the bottom when the pain becomes too much to bear.

Meb Faber’s 10 month rule is widely followed

To be clear, these aren’t just my musings. Meb Faber’s excellent research on tactical asset allocation became very widely cited and was extremely influential with asset allocators.  He tested a 10-month simple moving average on the S&P 500 with monthly trading rules, this is very similar to the 200 day period. I've replicated his results with my own data:

His approach shows almost identical regime splits. Faber's monthly approach generates far fewer signals (81 vs 369 over 56 years) and carries an 82% win rate on long trades versus 69% for the daily version. In some ways this is practical with less whipsaws, but of course, it can mean reacting more slowly to important signals.  

Daily or monthly, the message is the same - the S&P behaves fundamentally differently above and below its long-term moving average. It’s almost like there are two different markets within one index.   

An honest comparison with the AIM signal

I should be upfront about the limitations of using the S&P 500 timing model. It’s a useful indicator, but it's not the philosopher’s stone that it is for AIM.

For AIM, stepping aside when the index moves below the moving averages turned a -30% buy and hold loss into a +1,992% gain. AIM's bear markets are so vicious that avoiding them creates significant value.

But a long-only timing strategy on the S&P, which invests above the 200 day MA, and moves into cash when below returns just +6.9% annualised. This is actually less than just owning the index forever, which returned +8.1%. You give up about 1.2% of annual return in exchange for cutting your maximum drawdown in half. It’s a real tradeoff.

Long-term investors, who have long timeframes and are continuously saving, should not be overly concerned by market ups and downs.  Staying fully invested has been hard to beat.

So with the S&P, the moving average should be considered a risk management tool, rather than an outperformance generator. Selling when the index drops below the moving average is like paying a small insurance premium to avoid market crashes. Whether that trade is worth it depends entirely on your situation - if you are 21 with decades of investing and saving ahead of you, I’m sure you can ride out the volatility, but a 70-year-old drawing down their pension may see this rather differently.  

“Don't fight the Fed. Don't fight the tape”

There's a line from Marty Zweig that I've been quoting for years. Zweig famously predicted the 1987 stock market crash, and wrote the brilliant “Winning on Wall Street”. While Zweig had a range of market timing models, his simplest mantra was “Don't fight the Fed. Don't fight the Tape."   

Right now, being aggressively long is like fighting both.

By the “Tape”, Zweig meant the share price trend (the ticker tape was what share price quotes used to be printed on before digitisation). The trend of the tape, for now, is down.

But it's the Fed side that concerns me more. The disinflationary trend that gave the Fed and the Bank of England room for rate cuts has gone into reverse. It now seems like rate cuts are completely off the table - inflation is up, affordability is down, mortgage rates are being pulled, and gilt yields have rocketed in the last month. The US rate cycle also looks like it has turned, with the Fed boxed in between price input pressure and a slowing economy.

When both the Fed and the Tape are working against you - it’s a poor regime for shares - especially when the underlying market breadth is weak on both sides of the Atlantic.

Of course, not every break below moving averages leads to further declines or a crash.  About 31% of S&P 500 signals are false, quick dips followed by a recovery. 

Just this morning, Donald Trump mentioned that he's now seeking peace with Iran - and the S&P 500 futures are projecting a 1.5% rally into the open.   We'll all be delighted if there's a quick resolution to the Iran War and things get back to "normal".  

But the asymmetry is what matters. The cost of a false signal is small, you will only miss a small part of price recovery.  But the cost of ignoring a true signal can be high. The 2008 crisis took the S&P down 57%. COVID took it down 34% in weeks. In both cases, the moving average had you out before the worst of it.

Stop counting turkeys

I’ll leave you with a little story from Fred Kelly’s “Why you win or lose”.

“It dawned on me that my behavior was almost exactly the same as that of an old man I knew in boyhood. He had a turkey trap, a crude contrivance consisting of a big box with the door hinged at the top. This door was kept open by a prop to which was tied a piece of twine leading back a hundred feet or more to the operator…..

I remember going out with the old man one day and seeing a dozen turkeys in his box. Then one sauntered out, leaving eleven.

"Gosh, I wish I had pulled the string when all twelve were there," said the old man. "I'll wait a minute and maybe the other one will go back."

But while he waited for the twelfth turkey to return, two more walked out on him.

"I should have been satisfied with eleven," the trapper said. "Just as soon as I get one more back I'll pull the string"

But three more walked out. Still the man waited. Having once had twelve turkeys, he disliked going home with less than eight. He couldn't give up the idea that some of the original number would return. When finally only one turkey was left in the trap, he said:

"I'll wait until he walks out or another goes in, and then I'Il quit."

The solitary turkey went to join the others and the man returned empty-handed.