My drive into work consists of satellite radio and podcasts. I don't listen to rock 'n' roll to get pumped up for the workday that lies ahead. Instead, I flip back and forth between CNBC, Bloomberg and investment related podcasts. That's right, I'm aware that I'm the quintessential nerd. I'm passionate about investments and understand there's plenty of information available. I like to hear a variety of different opinions. I quite often hear the same discussion on many channels. Moving averages. Specifically, the 200-day moving average. I'm not sure why, but I cringe whenever it’s mentioned. I understand how this indicator works. Yet, I'm made to feel like the market will not open if it falls below this average.
It's used to fit different narratives. "We held the 200-day moving average, this is a win for the bulls." Or, "if we fall below the 200-day the bears have control." What is being said is somewhat accurate. At that moment in time. But, they tend to leave out the rest of the information. There's further data that must be factored in to clarify the signal strength. To make matters worse, there's a well-known signal based off this moving average called the "death cross." That's enough to frighten anyone. Maybe that's why so many people pay attention to this moving average.
I wanted to take a few moments to explain what a moving average is and why you shouldn't be nervous every time it's referenced. I apologize if there's any technical jargon. I'm attempting to avoid such lingo and merely get the concept across. There're different types of moving averages. Simple, exponential, Wilder's and Hull are a few. The calculation varies for each. They can also be calculated on multiple different timeframes. Among the most common are daily, weekly and monthly. I'm going to focus on the simple moving average for this explanation. The calculation behind it is quite simple, as the name implies. You add the closing price of a security for the number of time periods and then divide this total by the number of time periods. I've got good news. Most stock charting software does the calculation for you.
I've included an example below to visualize the calculation. I've also included a chart of the S&P 500. The 200-day moving average is the purple line.
Example:3-day simple moving average,Closing price + closing price + closing price / number of periods = simple moving average
Is it bad when we fall below the 200-day moving average? Well, yes and no. Things are not as straightforward as people would like to make you believe. Context is important. We need to consider many variables. Is the slope of the moving average up or down? Has priced closed below the moving average? Are we in a strong up trending market? Is this the first break below? You get my point. There’s more to it than, "we crossed below the 200, get me out!"
I won't bore you with all the statistics. But, over the history of the S&P 500 there's been numerous breaks below this moving average. Yes, some of the breaks did turn into bear markets. Yet, many times it turned out to be a false signal and we went on to make new highs shortly thereafter.
I will not argue that bad things can certainly happen below this average. Especially if the average itself is sloping downwards. I don't want anyone to think I'm bashing moving averages. Quite the opposite. I think they're a valuable indicator. It helps us see the current price in relation to the average of a specified number of periods. Also, they can accompany other indicators to help confirm a thesis. However, they are not the most reliable timing system when used alone. In my opinion they’re not a clear buy and sell signal. Following such a system would cause an investors account to get chopped up by commissions and false signals over time. It may also cause you to miss out on some strong up trending days. Or, it may work, and you’ll feel like you found the holy grail of indicators.
At some point in the future this will be the hot topic of conversation once again. If the moving average panic ensues, take a moment and remind yourself that it's simply an average of price over time. Ask yourself this question. If I didn't know there were such thing as a moving average, would I still be buying or selling at this time? Take note, factor in other variables and decide whether it’s something to act upon. Most importantly, remember that just because one investor is buying or selling, doesn't mean that you should blindly follow suit. Stick to the strategy that is based upon your timeframe and goals. Not the goals of others. If you would like to find out more, click here.
The indexes mentioned in this communication are unmanaged and not available for direct investment. Past performance is no guarantee of future results. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information contained in this commentary has been obtained from sources that are reliable. This presentation is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.