A Rule for the Ages: The Simple Moving Average

 

Wall Street is full of rules and anecdotes that are usually grounded in hard and fast data, human nature, or both. Most of them work most of the time, but there is also always the chance that “this time” will be different. Indeed, nothing sets a contrarian’s instincts fluttering more than when pundits and strategists start decrying why a particular move will be “different” than all the others. It is very rarely true, since the forces of greed, fear and math remain the same across markets, sectors, trends and time.  

Yet some of these rules are actually very powerful tools, if for no other reason than most traders and investors pay attention to them. This is particularly true in the world of technical analysis, or the use of charts and other graphic displays of data to glean future direction. Adherents of this type of analysis care little about why a particular stock’s price moves, but rather by how much it has moved, for how long, and to which levels.

Interestingly, much of the chart analysis relies on historical tendencies. Things like Elliot Wave, Fibonnacci analysis, and patterns like head-and-shoulders formations are based almost entirely on how prices have reacted in the past. Analysis based almost entirely on mathematical relationships is concluded with words like “usually” and some percentage of times in the past that the indicator has worked. They can much more susceptible to being “different this time” than many others.

Simple moving averages are among the most effective history-based technical indicators. They’re so popular because they illustrate the general inertia of stock prices—the tendency of a stock, once it is in motion in a particular direction, to stay in motion. In market circles, it has a variety of names: momentum investing, the bandwagon effect, the greater fool theory, etc. Investors, although they generally know better, are pre-disposed to owning stocks that have been going up, and selling those that have been going down. It’s really that simple. Basic common sense tells us that the best buys are apt to be the stocks that have already done well this year, but in reality, investors that buy last year’s best-performing stocks have very good odds of having strong performers again. Commodity and currency markets exhibit the same tendency.

For a variety of reasons, the 50-day and the 200-day moving averages have become the standard measures of short and long-term momentum, respectively. By graphing these averages against a particular security’s price, a line illustrating that security’s general trend can be created. Accordingly, when the security is trading above its 200-day moving average, it’s considered to be in an uptrend, and below it, in a downtrend. Even better, when the 50-day and the 200-day lines cross, look out— either the trend is about to change or it has just been confirmed.

So many people follow these two moving averages that they have been turned into self-fulfilling prophecies. The market performs best when the major indices are above their 200-day moving averages, and does little when they are beneath them. Since every trader with a workstation is expecting it, a stock or index will often test its 200-day moving average line two or three times during shifts in trend. For the same reason, a major index that breaks through its 200-day average in either direction has very good chances of accelerating its move in that direction.

Case in point: The S&P 500 had been trading comfortably above its 200-day moving average throughout this year, but deteriorating economic data began to put pressure on the index by late spring and it gradually narrowed the gap. It bounced two times off its 200-day average a few weeks ago before conclusively breaking through it on August 2nd. A few days later, the floodgates opened, the S&P 500 dropped sharply and ended that week nearly 7% below the average. Following the momentum theory, it is highly likely that the overall market will at best remain in limbo until it is able to cross back over its long-term moving average.

That said, there is a flip side to this type of thinking. Historically, when more than 80% of the stocks on the New York Stock Exchange fall below their 200-day moving averages, the entire stock market is washed out, i.e. oversold, and very near a turn. As we went to press, only roughly 17% of NYSE stocks were above this level, marking the eighth time since 1994 that readings have been this extreme. In each of the seven prior cases, the market was higher both two weeks and three months later, suggesting that although the path of least resistance seems to be down, the market is actually more likely to turn positive over the next several weeks.