How Useful is the 200 Day Moving Average?
Wed, Jun 3, 2:55 PM ET, by Kenneth C. Bateman
Anyone who follows the market closely knows that the 200 day moving average (200-dma) is a trend line that needs to be followed. Even investors who are strictly fundamental in nature often steal a glance at the 200-dma. The 200-dma is seen as both a significant point of resistance and a significant point of strength.
To demonstrate, consider this chart below of the S&P 500 index which encompasses the majority of the last bull market.The blue line, representing the 200-dma, proved to be a good point to add to long positions on weakness.
The mainstream financial media is now suggesting that this rally has exceeded the 200-dma and provides further confirmation that we are in a bull market. This is not said explicitly, but is merely mentioned as another indicator of the obviousness of the bull market, and further proof the bear market has ended. In fact, this is a much different assertion that what the above chart indicates.
With this in mind, I want to look at prior instances of the stock market rallying to the 200-dma. Exactly how good of an indicator is the 200-dma in determining the end of bear markets, rather than actually proving to be a good time to be a seller of stock.
The chart below shows our current rally.
This is our current rally, up from the March lows of 666.79 on the S&P 500. Clearly we have had a great surge of strength in this current rally. But the real question that investors need to ask themselves is whether or not this presents an opportunity to buy or sell equity positions.
Our next example of the S&P 500 comes from 2008. If you remember, this was following Bear Stearns and the extraordinary actions of the Federal Reserve to aid the financial system. The general consensus was that the Fed had saved the day. The thinking was we would no longer be required to endure the prospect of a systemic collapse because the Federal Reserve made the discount window available to Investment Banks. The market had dropped, and rallied back to the 200-dma, a sign of strength. In retrospect, the S&P 500 touching the 200-dma proved to be the single best time to sell, not to buy. I have spared you from viewing how the rest of 2008 turned out.
Here is another chart of a bear market rally that touched the 200-dma several times, yet still finally resolved to the downside.
This chart comes from 2001, in the post-internet bubble, a time of decidely high valuations. The rally from the low in September of 2001, which was 944.75, to the high of 1176.97 in January 2002 was a gain of 24.5%. The S&P 500 broke the 200-dma, but was this a clarion call to buy? Absolutely not, it was a clarion call to sell, as the remainder of the chart demonstrates.
Below is a daily chart showing the entire 3-year period September 2000 to September 2003. There were several “touches” of the 200-dma, and almost all of them produced a good opportunity to exit equity positions in front of future weakness.
Of course, there is a magical time when the 200-dma presents an opportunity to buy stocks, as is shown in the above chart in April 2003. But given the success ratio of the 200-dma, it is foolhardy to assume that this alone is a premier metric to use to determine that “now is the time to get in.”
Even when it did finally break the 200-dma, there was still plenty of time to gain exposure to equities for the bull market between 2003-2007 – see the first chart.
So while others expound on the recent break of the 200-dma for the S&P 500, this is far from a call to action for investment. The 200-dma is only a tool to be used in conjuction with other forms of analysis, including analysis of the broader economy.
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| There are really 2 different usages of the 200-day MA. Treating them separately resolves some of the confusion and really makes it easier to determine what has worked and what doesn't.
Usage 1: Sentiment indicator: e.g. when price is somewhere above the 200 MA then look for signals to go long
Usage 2: Entry trigger: e.g. buy when the price crosses up through the moving averages.
I backtested both usages for 200 day MA (and others) over 14 yrs of data for 7147 stocks. Results showed that one way of using the 200 day moving average added value and other didn't. See www.backtestingblog.com for more info.
-- Jackie Ann Patterson
Thu, Jun 4, 3:00 PM ET
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