Thursday, August 2, 2007

Technical Thursdays: Avoiding the Noise with Moving Averages

When markets get this volatile, investors benefit greatly by keeping their eye on the longer-term investment ball. And no technical analysis tool does this better than the moving average. By smoothing out the short term wiggles and squiggles of the market, moving averages help investors avoid getting caught up in the noise of the moment. It has been my experience, however, that more than a few investors are not clear on how to best utilize this tool. Here are a few suggestions:

The most often cited value in moving averages is their current price point. For example, yesterday’s market saw the S&P 500 briefly trade at, then through, its 200-day moving average, only close well above it (see left chart above). However, as useful as a specific price point might be, I have found that the direction and slope of the 200-day moving average, along with its interaction with other moving averages and the current price level of the index to be the most productive and predictive aspect of a moving average. To illustrate, consider the second chart above, which is a longer-term picture of the S&P 500 (from Jan. 1, 1995 to the present).

Note how the index’s current price oscillates around the largely meaningless (on its own) short-term 50-day moving average and occasionally trades through its (far more valuable) longer-term 200-day moving average. More importantly, however, note the slope of the 200-day moving average, headed in a defined direction for years at a time. As can be seen, once a mega trend is in place, it tends to stay that way, that is until a confluence of events (fundamental or technical) shifts it to its opposite direction. Now, also note the interplay between the current price and the 50-day moving average with the 200-day.

When the 200-day’s slope is set (up or down), the current price and the 50 day tends to lead in that direction (above or below). In other words, a mega trend contains two elements: the current price and the 50-day moving average must lead the 200-day and the slope of the 200-day must point in a clearly defined direction.

A preliminary warning signal to a mega trend occurs when the current price crosses the 200-day. A slightly more significant warning signal occurs when the 50-day crosses the 200-day. BUT, it is only when both current price and 50-day cross the 200-day AND the 200-day changes direction that the existing mega trend can be considered over.

Investment Strategy Implications

Until the level of the current price and the 50-day moving average cross the 200-day AND the slope of the 200-day points downward, the current mega trend is intact. Since both of these conditions do not exist, it therefore must be assumed that what the markets are currently experiencing is a correction and not a mega trend reversal.

Note: The current three mega cycles noted above do not show the infrequent crisscrossing of price and moving averages which then tilts the slope of the 200-day in the opposite direction of its existing mega trend only to revert back to its previous direction. Such occurrences may produce a temporary John Kerry-like flip-flop effect but that is both infrequent and temporary. The mega trend to be does establish itself in relatively short order.

Also, note that to view a larger version of the above image, simply click on the image.

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