Time to Pack Away the 200-day Moving Average?

Monday, September 27, 2010

The 200-day moving average, one of the screens I recently used, could be starting to reach the end of its usefulness.

It may seem odd, but this longer-term measure often has only short-term value. Here’s why…

First, the basics

The 200-day moving average is a “simple” sum of 200 closing prices, divided by 200. Referred to as the 200-day SMA (“simple moving average”), this long-used measure remains popular.

Second, why 200 days?

This commonly used time period is valuable for two reasons:

  1. Through trial and error, investors found the period to be long enough to smooth out short-term volatility and short enough to capture a trend’s important movements in a timely manner.
  2. “Commonly used” means many investors are watching it – therefore, we should, too.

Note: Prior to around 1970, investors tracked data and made calculations by hand, so shortcuts were taken. A popular one was to use the average of 30 weekly closes as the 200-day moving average. Why? Because 30 Fridays spanned 204 days (the first Friday + 29 weeks of 7 days). Today, common usage is to count trading days, so 30 weeks is thought of as 150 days. Therefore, the 200-day moving average now represents about 40 weeks.

Third, when is it most useful?

There are three especially good periods when the 200-day SMA can provide helpful information:

  • During a bear market. When the market is trending down, prices are running below the SMA, and the SMA, itself, is trending down. At some point a downtrend runs out of gas and reverses itself, either temporarily or as a new bull market. The initial sign is prices rising above the SMA. If that price move is able to hold long enough, then the SMA, itself, can flatten out and begin to rise. Many investors watch both individual stocks and indexes for these signs. (This happened in 2009, following the March bottom.)
  • During a bull market. As with a bear market, the SMA can help spot the end as the stock market shifts away from its upward trend. At such tops, however, the indicator can lag too much. Typically, drops are faster than rises, meaning the 200 days can be too long a time period. By the time the SMA rolls over, the stock or market can be a long way down. Perhaps more valuable is the lack of a signal – i.e., the price or index doesn’t break below the SMA, thereby providing a confirmation of sorts that the uptrend remains intact.
  • During a sideways market. This is what we have been in recently, as shown in the graph below. (It may not have felt sideways, with all the volatility, but the 200-day moving average shows its value in seeing through the ups and downs.) In such periods, the SMA can be helpful in value screening.

Note that the 8% rise this month moved the DJIA from 4.2% under its 200-day moving average to 3.8% above it. This shift affected screening for stock prices below their 200-day SMAs. Out of the 500 stocks in the S&P 500 Stock Index, 293 were below on August 31. As of Friday’s close (September 24), the number had been cut to 162. Increasing the screen to SMA + 5% raised that number to 251, but that’s only a temporary cure. A further rise will reduce the number of stocks even more, essentially making this screen unhelpful.

Fourth, when is it less useful?

The SMA has limited use in other markets. It can help with individual stocks or industries that have been out of favor. However, once we are in a “normal” bull market (doesn’t that sound nice?), the 200-day moving average tends to remain a lagging measure. Screening for lower prices then starts producing lists of flawed stocks that are deservedly cheap. In bull markets, there are too many people combing the data to allow true bargains to go un-bought.

Fifth, other uses

Some investors track other time periods (e.g., 100-day, 50-day and 20-day SMAs), then watch how they behave versus both the stock/index levels and even other SMAs. Sometimes such work helps – sometimes, not. Speed is variable in the stock market, so knowing which SMA is the one to use at any given time requires some challenging assumptions.

Additional information on other uses is available at StockCharts.com – ChartSchool: “Technical Indicators and Overlays – Moving Averages

So… If the stock market continues its uptrend, the 200-day moving average likely will be packed away.

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John Tobey on Seeking Alpha

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September 2010