I came across a paper entitled A Quantitative Approach to Tactical Asset Allocation by Mebane Faber. This paper appears to have been extremely popular over the years. Reading through the contents and reviewing the charts, I loudly wondered if the strategy might apply to gold.

Rules for buying gold

The idea is very simple. Taken directly from the paper, the rules are:

BUY RULE
Buy when monthly price > 10-month SMA.

SELL RULE
Sell and move to cash when monthly price < 10-month SMA.

1. All entry and exit prices are on the day of the signal at the close. The model is only
updated once a month on the last day of the month. Price fluctuations during the rest of
the month are ignored.
2. All data series are total return series including dividends, updated monthly.
3. Cash returns are estimated with 90-day Treasury bills, and margin rates (for leveraged
models to be discussed later) are estimated with the broker call rate.
4. Taxes, commissions, and slippage are excluded.

Test results

The tests were done using Kinetick’s free end of day data. The data extends from August 4, 1997 until December 10, 2012.

One thing which drives me crazy about NinjaTrader is that the percent return calculations are so opaque. The actual numbers used a clearly wrong. The buy and hold return for gold is easy to calculate. The 1997 price was about $350 an ounce. Today, gold trades near $1,700. The buy and hold return should be in the neighborhood of 385%. NinjaTrader claims that the return is somewhere near 150%. I’ve gone through the charts to confirm that the trades are correct. You can download the gold strategy for NinjaTrader and verify the trades for yourself.

The percent return metric is consistent within the platform, so luckily the exact numbers are unimportant. The only thing that really matters is whether or not the strategy returns a bigger number than the buy and hold approach.

A chart of gold’s daily equity curve, extending back to June 1997.
The tactical gold strategy dramatically underperforms the buy and hold return.	Pursuing the opposite idea of buying on crosses underneath the SMA10 doesn’t help

The strategy severely underperforms the buy and hold return. The idea held in the paper itself is deeply flawed. Buy and hold is a silly concept. Most of the “returns” in the portfolio stem from long term inflation and the devaluing of the dollar. The prices of the securities rose because the dollar, which you can think of as the counter currency, declined enormously in value over this time period.

Additionally, the idea of the price crossing the moving average implies that the trend escapes the moving average. The MA, in effect, gets dragged along with the price. While this is true with a handful of monster trends, the way that price moves usually work is something along the lines of 10 steps forward, 9 steps backward. The results of the test indicate this.

If the proposed strategy returns less than buy and hold and the total buy and hold strategy returned 150%, then it stands to reason that the total buying return is trades taken by the strategy + trades not taken by the strategy. The test includes what are supposed to be trades not taken by the strategy – the reverse signals. Adding up the proposed strategy’s returns with the returns of the opposite signal only accounts for roughly one third (22% + 34%) of the 150% earned. Where did the rest of the money go?

Most of the move happens around the short term moving average. The majority of the move has already happened after the price to crosses and closes above the moving average. The instinct of many novice strategy developers is to move to intrabar signals. Intrabar trading ignores the basic problem; you cannot know whether or not the bar will close above the moving average.