Moving Averages Can Help in Spotting Trends

Now what?

After exploding during the first three months of the year, the stock market and mutual fund prices have cooled off in recent weeks. Is this merely a pause in an upward cycle, or does it signal the start of another major downdraft?

Such are the questions that trend followers don’t have to answer. They base their buy and sell decisions on the objective evaluation of mutual fund price charts, rather than on their own emotions, opinions or gut feelings.

Many trend followers focus on the link between a fund’s current price and its moving average in deciding whether to stay invested or switch to the safety of cash. A moving average is simply a plotted line that smoothes out a fund’s daily price fluctuations, so that you can better spot the underlying trend.

To construct a five-day moving average, for example, you would simply add up a fund’s closing price for each of the five most recent days, then divide by five. Tomorrow, you would include that day’s price, drop the one from six days ago, and again divide by five. By plotting each day’s result against the daily price, you can identify the fund’s trend.

You can construct moving averages for virtually any security, as well as for market indicators such as the Dow Jones industrials. Moving averages work particularly well on stock mutual funds because they don’t fluctuate too dramatically, says Ray Hansen of Financial Growth Management, an investment-advisory firm in Orange. Because they’re diversified, equity portfolios rarely move more than 3% or 4% in a day, while a stock might rise or fall 20%.

Moving averages are highly versatile--you can build one for any period you choose. Jack Heilbron, chairman of Centurion Counsel, a San Diego investment-advisory firm, bases his buy and sell decisions on a variety of factors, including moving averages of five, 20, 50, 75, 90 and 200 days. Hansen also looks at short-term averages, although he won’t specify which ones.

By contrast, the trend-following Telephone Switch Newsletter of Huntington Beach takes a longer-term approach. It focuses on a single 39-week time frame, tracking four moving averages over that period.

On the basis of its moving-average signals, Telephone Switch Newsletter generated a 15.8% annual compounded gain between June 30, 1980, and Dec. 31, 1990, according to the Hulbert Financial Digest, a tracking service in Alexandria, Va. That compares to 14.2% a year for the broad Wilshire 5,000 equity index. (For the purpose of this study, Hulbert assumed the newsletter switched between cash and the Wilshire 5,000, rather than specific mutual funds, to isolate the effect of the timing signals.)

A shorter-term moving average will produce more buy and sell signals than a lengthier one. “We’re in the market on average only four to 10 days at a time,” Heilbron says. Hansen makes a “round-trip” move every two months or so (each round trip involves switching from cash to a stock fund, then back to cash). But subscribers to Telephone Switch Newsletter, with its longer-term focus, face only about one round trip a year on average.

Heilbron argues that shorter moving averages can produce better results. For people who want to try market timing on their own, he recommends using a 50-day average.

But if you don’t have time to follow your investments closely, you might want to track a longer-term moving average (or enlist the help of a professional money manager). Also, keep in mind that each switch results in a taxable transaction, unless you’re holding funds within an IRA or other tax-sheltered account. So while short-term traders don’t necessarily run up greater tax liabilities, they do have more paperwork.

Another caveat: Several mutual fund companies restrict trend followers and other market timers to four round trips a year. This is because sudden movements of large sums of cash in or out of a fund can cause havoc for the portfolio manager. Before you embark on a timing strategy, check your fund family’s switch rules by calling the company or reading the prospectus.

Trend followers key on those instances when a moving average intersects a fund’s price line. When the current price drops below the average, that’s bearish because it portends further weakness ahead. By contrast, when a fund’s price breaks above its moving average, that’s a bullish signal of strength. To avoid whipsaws or misleading signals, some market timers require the price line to exceed or fall below the moving average by 3% or so before they will act.

Just make sure you spell out your ground rules before crunch time. For a moving average approach to work, you should follow it consistently. “You need the discipline to actually act on the signals,” Hansen says. “Yet many people find it hard to pull the trigger when they’re investing their own money.”

There’s nothing especially difficult about crunching the numbers on a moving average--a hand-held calculator can do the job. But you can get the work done more quickly with the help of a personal computer.

Frederic Shipley, a De Paul University professor and computer editor for the American Assn, of Individual Investors in Chicago, likes a program called Fund Master TC for people with an IBM or IBM-compatible personal computer. “This software will construct a whole bunch of charts and moving averages and will give you portfolio updates,” he says.

For Apple Macintosh users, Shipley suggests Wall Street Watcher. And he recommends Compu Trac for more sophisticated investors; it’s available in both IBM and Macintosh versions.

However, Shipley believes that there’s little evidence to support the notion that a moving average-based timing system can beat a simple buy-and-hold strategy.

In fact, this is one of the hotter debates in the investment arena: whether market timers, with their moving averages and other tools, can beat an unmanaged benchmark such as the Standard & Poor’s 500 or Wilshire 5,000. Timers insist they can, although they put a different spin on the argument: They vow to match the market’s return while exposing investors to less overall risk by keeping them in cash during bearish phases.

In short, moving averages can give you an objective means of knowing when to buy and sell. And that can help wring guesswork and emotions out of your investment decisions.