A Coupla ‘Average’ Guys : Moving Averages Get Heavy Consideration in Trading Decisions

If I knew you ate granola and bananas for breakfast every day for the last nine months, it’s not much of a stretch to predict that you’ll eat either granola or bananas tomorrow.

In a nutshell, that’s the reasoning behind a remarkably successful set of techniques that relies almost exclusively on the moving average of share prices to decide when to buy and sell stocks. The theory is that although the recent past may not perfectly foreshadow the future, it certainly offers powerful clues.

Moving averages of major market indexes point straight up toward 1997, despite the terrific run in prices over the last six years, according to two of the nation’s most prominent advocates of moving-average systems: Nelson Freeburg Jr. and Doug Fabian.

Their systems are not too complicated but do require mastery of a pencil and calculator, or, better yet, a computer spreadsheet program. Also, you’ve got to accept the unpopular view that it is possible to time the market successfully.

First, note that a moving average provides a snapshot of where a stock price or market index is now relative to its recent trend. To calculate a typical short-term moving average for the last 15 days, simply add up a stock or market index’s closing prices over the previous 15 market days and divide by 15. For a more intermediate nine-month picture, add the closing prices of the last 39 weeks and divide by 39.

Many investment sites on the Internet’s World Wide Web, such as PC Quote (https://www.pcquote.com), Microsoft Investor (https://investor.msn.com) and DBC Online (https://www.dbc.com), offer moving-average charts for free or a minimal charge.

Freeburg, publisher of the Formula Research newsletter in Memphis, Tenn. ($195 per year, [800] 720-1080), has developed trading systems based on moving averages over the last 20 years and garnered top-drawer clients such as money manager Martin Zweig and Goldman Sachs’ research department.

Freeburg believes 70% of a stock’s movement can be explained by trends in the overall market, not the company’s fundamentals. As proof, he notes that in every major correction, including the one in July, high-quality stocks such as Intel, GE and Microsoft are beaten up without regard to their superior qualities.

However, he thinks that moving averages by themselves mean little unless used with other indicators, mainly changes in interest rates.

Freeburg calls one of his best and most simple methods PAL, after rules governing the launch of nuclear missiles from U.S. submarines. Like the Navy’s Permissive Action Link protocol, which keeps warheads in their bays until a series of authorizations are given for release, PAL investors leave 100% of their money in the market until specific signals arise.

Under the rules of engagement, a PAL investor buys a mutual fund mimicking the large-capitalization stocks in the Standard & Poor’s 500 index, such as Vanguard Index Trust 500 or Rydex Nova, and holds until the S&P; 500 index falls below its 42-week moving average and either the yield on the 30-year Treasury bond rises above its 42-week moving average or the yield on 90-day Treasury bills moves above its 10-week moving average.

When a sell signal is generated, conservative money is switched out of stocks and parked in a money market account; aggressive money is placed in the Rydex Ursa fund, which shorts S&P; 500 futures contracts (i.e., a bet on a falling market). Generally, such strategies shouldn’t be used with funds of companies, like Fidelity, that charge investors who switch in and out of a fund more than four times a year.

If you had stumbled upon the PAL system on Jan. 8, 1954, and laid down $10,000, Freeburg says, you would have $5.2 million (at least, before taxes or trading fees) in your account today--an average annualized return of 15.7%. Simply buying and holding the S&P; 500 for the same period, he said, would have put just $1.5 million in your account--an annual return of 12.3%.

The model’s last signal was a buy, issued on Dec. 16, 1994, so PAL followers have been fully invested since then. Money invested then had grown 72.8% through November.

The strategy works, Freeburg says, because the bond market is the most reliable leading indicator of the stock market. When interest rates fall, stocks become more appealing to investors; conversely, a rise in rates makes stocks less appealing.

Sound too complicated?

Then check out a simpler but similar market-timing strategy described every two weeks in a newsletter published by Fabian Premium Investment Resources in Huntington Beach ($179 per year; [714] 536-2201; https://www.fabian.com).

Doug Fabian has built a following of 30,000 readers with a method that has wrung a 15.8% annual compounded return from the market since 1977. It’s best followed in the well-designed letter, but it can be done with a spreadsheet, too.

Fabian follows specific indicators for particular markets. One is what he calls the Domestic Fund Index--an index of share prices of five large mutual funds (currently, Kaufmann Fund, 20th Century Ultra, Fidelity Magellan, Founders Growth and Scudder Capital Growth.

The second indicator is the Dow Jones 65 composite--a combination of the Dow industrial, utilities and transportation averages.

Whenever the domestic fund composite and the Dow composite are above their individual 39-week moving averages, a stock market buy signal is in effect, according to Fabian. When both drop below their 39-week averages, it’s time to sell. However, to avoid being whipsawed with frequent buys and sells, Fabian in 1995 added a filter that delays a shift until the market moves out of a 5% range relative to its moving average.

The Fabian approach lags the overall market this year, with a 10.9% gain to date, mainly because it pulled investors out of stocks on July 15--a bit too far into the sell-off--and stayed away during part of the August recovery.

There are, of course, dozens more ways to use moving averages to purchase and sell individual stocks.

David W. White, investment strategist at the Headlands Group in San Francisco, notes that some technical analysts believe the time to buy an individual stock is when its 50-day moving average goes above its 200-day moving average. Other techies, he says, get a buy signal only when the 50-day moving average is above the 200-day average and the current price is also above the 50-day average.

Michael K. Farr, a principal of Farr, Miller & Washington in Washington, looks at a stock’s 50-day moving average only to assist in the timing of a transaction after he’s made a decision to buy based on fundamental analysis. “When a stock is trading right on top of its 50, that’s a fine time to buy,” he says. “If you see it trading well above, wait a few days.”

On the other hand, he concedes, all the fretting and fussing over day-to-day prices “won’t make one damn bit of difference” long-term.

Street Strategies explores investment tactics. Jon D. Markman is a Times staff writer. He can be reached at jon.markman@latimes.com

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Timing Is Everything

Nelson Freeburg’s PAL market-timing system has seen 15.7% annual compounded returns since 1954; it has returned 72.8% since Dec. 16, 1994. A PAL investor buys a mutual fund mimicking the entire stock market, like the Vanguard Index Trust 500, and holds until the Standard & Poor’s 500 index falls below its 42-week moving average and either the yield on the 30-year Treasury bond rises above its 42-week moving average or the yield on 90-day Treasury bills drops below its 10-week moving average. PAL timing decisions since Oct.4, 1985:

*--*

Buy date Buy price Sell date Sell price % Gain/loss 10/04/85 $2,316.90 9/12/86 $3,016.68 30.2% 9/19/86 3,038.86 9/26/86 3,041.17 0.1 10/03/86 3,062.59 10/16/87 3,821.00 24.8 11/06/87 3,391.43 11/27/87 3,261.85 -3.8 12/04/87 3,041.31 12/18/87 3,388.88 11.4 1/08/88 3,317.43 1/29/88 3,510.91 5.8 2/05/88 3,429.82 3/25/88 3,549.40 3.5 6/10/88 3,752.79 1/26/90 4,768.89 27.1 3/16/90 5,027.97 3/23/90 4,962.29 -1.3 4/12/90 5,077.06 4/20/90 4,944.44 -2.6 5/11/90 5,203.84 8/03/90 5,137.59 -1.3 8/10/90 5,001.88 8/17/90 4,890.68 -2.2 10/12/90 4,502.42 10/19/90 4,692.73 4.2 10/26/90 4,579.51 1/18/91 5,036.52 10.0 1/25/91 5,098.27 11/29/91 5,,846.60 14.7 12/13/91 5,997.94 10/02/92 6,557.61 9.3 1/25/91 5,098.27 11/29/91 5,846.60 14.7 12/13/91 5,997.94 10/02/92 6,557.61 9.3 10/09/92 6,436.67 10/16/92 6,585.48 2.3 10/23/92 6,627.22 3/25/94 7,665.83 15.7 8/12/94 7,772.61 9/23/94 7,,758.71 -0.2 9/30/94 7,813.86 10/07/94 7,689.86 -1.6 10/14/94 7,930.59 11/25/94 7,671.05 -3.3 12/16/94 7,794.37 11/29/96 13,470.75* 72.8

*--*

* portfolio value as of Nov. 29

NOTE: Buy and sell prices refer to a total return index of the S&P; 500. The index takes into account reinvested dividends.

Source: Nelson Freeburg, Formula Research newsletter