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The water is fine. Come on in. In other words, the water is colder than a good gin and tonic. Diving into the lake is not recommended.

Investors looking at the stock market are similarly nervous about its waters, which have been less than inviting this year.

A thermometer solves the beach-goers dilemma and I use one to test the lake at the start of my summer break. Investors can also use tools to gauge whether the market is hot or not.

Today I check on one such tool that comes in the form of a classic trend-following technique. More specifically, I look at how a simple moving-average strategy fared as a market timing method over the past few decades. The idea is to try to get most of the stock market’s upside in sunny times and to scurry back to bonds when the weather turns sour.

My moving-average portfolio is either all in on Canadian stocks, as represented by the S&P/TSX Composite Index, or it’s all in on Canadian bonds, as represented by the S&P Canada Aggregate Bond Index. It chooses between the two by looking at the stock index’s value at the end of each month and comparing it with the average value of the stock index over the prior year. The portfolio moves into stocks when the index is above its 12-month average and into bonds when it is not. (I use monthly data and the total return version of both indexes, which include distribution reinvestment. The returns herein do not include fees, trading frictions, taxes or inflation.)

The moving-average portfolio gained an average of 10.4 per cent annually from the end of 1994 through to the end of June, 2020. It beat a buy-and-hold investment in the stock index, which climbed 7.8 per cent annually over the same period. The bond index fared reasonably well but lagged both with annual returns of 6.3 per cent.

You can examine the return history of the moving-average portfolio and both indexes in the accompanying graph.

The moving-average strategy generated extra returns, but it also required extra effort. After all, an investor following it would have to track the market and make a trading decision once a month. They traded (from the stock index to the bond index, or vice versa) a little more than once a year on average over the period.

The moving-average portfolio shielded investors from the full brunt of market crashes. The second graph shows its downside performance. The graph illustrates how far the portfolio, and the stock index, fell from their prior highs in downturns.

The stock index suffered from two 43-per-cent declines in recent decades. The first occurred after the internet-fuelled bubble burst in the summer of 2000. The second plummet was prompted by the financial collapse of 2008.

The moving-average portfolio escaped from the worst of both downturns, but it was not entirely unscathed. It fell 21 per cent when the internet bubble burst and 24 per cent in the financial crisis.

The portfolio was tested again this year by the COVID-19 crash, which saw the stock market fall 22 per cent from its peak. The portfolio got a mild case of the bug, but it fell just 8 per cent by the end of March.

More recently, the moving-average method steered clear of the stock market at the end of June. It decided to sun itself on the beach and stayed in bonds instead. However, the stock market climbed in the early weeks of July. Should it remain near current levels, or move higher, the portfolio will likely shake off the sand and dive into stocks at the end of July. The lake might also be warm by then.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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