Theoretical Support for the Moving Average Crossover

Advisor Perspectives welcomes guest contributions. The views presented here represent those of the author and do not necessarily represent those of Advisor Perspectives or of Capital Advisors, Inc.

This article matches an appropriate descriptive theory about how asset markets work with a recently published normative theory about using the moving average crossover as an indicator for timing portfolio changes in active portfolio management strategies. Specifically, I propose that the theory of “Rational Belief Equilibrium” in asset markets, developed by Stanford University professor, Mordecai Kurz, helps to explain why moving average crossovers have demonstrated predictive value in the stock market in the past, and why they might continue to offer predictive value in the future. I make specific reference to a series of recent articles on the subject of moving average crossovers, by Theodore Wong, published in Advisor Perspectives.

A recent series of articles written by Theodore Wong offers compelling empirical support for the “Moving Average Crossover (MAC) System” as an alternative to buy-and-hold in the asset markets (See Advisor Perspectives: What the “Missing Out” Argument Misses, Moving Average: Holy Grail or Fairy Tale – Part 1, Moving Average: Holy Grail or Fairy Tale – Part 2, Moving Average: Holy Grail or Fairy Tale – Part 3). Mr. Wong’s evidence is compelling. His research demonstrates that a simple, rules-based trading discipline that goes long the S&P 500 Index when the index is trading above its 6-month moving average, while shifting to cash when the index is below its 6-month moving average, generates superior risk-adjusted returns relative to buy-and-hold over most intermediate and long-term holding periods for the index dating back to 1871.

Despite the evidence in favor of the strategy, die-hard proponents of buy-and-hold investing might still contend that Mr. Wong’s empirical support for the MAC System is incomplete because it lacks a proper theory to explain why the system works – the way the theory of efficient markets (EMH) supports a buy-and-hold investment prescription, for example. “The data is fascinating,” a proponent for efficient markets might say, “but why should anyone expect the MAC System to be effective in the future just because it worked during a small sample period of (ahem) 137 years?”

Although Mr. Wong does not expand into descriptive theory to support the MAC System in the articles listed above, such a theory does exist. It is called “Rational Belief Equilibrium” (RBE), and it was developed at Stanford University over the past 15 years by Economics professor Mordecai Kurz (See: "Endogenous Uncertainty and Rational Belief Equilibrium: A Unified Theory of Market Volatility," Mordecai Kurz, Stanford University, July 1999).

RBE represents a true advance in our understanding of asset market behavior. It generalizes its primary predecessor theory – EMH – by resituating EMH as a special case within a broader descriptive theory of how asset markets work. RBE explains why asset markets tend toward cycles – bull and bear markets, booms and busts – in a way that EMH never could.