'Golden Cross' strategy works well in US market

April 08, 2019 11:35
Wall Street has seen a short-term moving average of the S&P 500 index cross above its long-term average, boosting investor optimism. Photo: Reuters

The “golden cross” signal, which typically refers to the 50-day moving average crossing above the 200-day moving average, showed up in both S&P 500 and Russell 1000 Index On March 25.

Last time when the signal came out in 2016, the index went up 40 percent afterwards, until the reversal sign, or a "death cross" (50-day moving average crossing below the long-term moving average) appeared.

Does the golden cross of S&P 500 serve as a reliable entry signal over a longer period?

Let’s do a backtest using historical data for last 70 years to find out.

Thirty eight golden crosses of the S&P500 index have been triggered since 1940s, including the latest one.

In the previous 37 cases, the strategy of buying with golden cross and selling with death cross generated positive returns 27 times.

Using this trading mechanism, a principal of HK$100,000 would grow to HK$13.44 million after seven decades or so, which represents compound annual growth rate (CAGR) of 6.7 percent.

By contrast, a simple buy-and-hold strategy gives a CAGR of 7.1 percent. However, the former strategy means investors were exposed to the market for only two thirds of the time.

Both buy-and-hold and golden cross strategies have an obvious weakness -- maximum drawdown, or the maximum loss from a peak to a trough of a portfolio.

Their maximum drawdown was -33.3 percent and -56.8 percent respectively. But we can improve the method by inserting a stop loss limit.

For example, if we add a 15 percent trailing stop order, the revised golden cross strategy would have a CAGR of 6.6 percent with a maximum drawdown of -22.2 percent.

Though the return is marginally lower, the maximum drawdown has become markedly less, suggesting that trailing stop is very effective in risk management of golden cross strategy.

This article appeared in the Hong Kong Economic Journal on April 4

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist