Technical Thursdays: This Thing Called Moving Averages

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To paraphrase Ronald Reagan: "There they go again."

Every time the stock market’s major indices slump to their 200-day moving average, the bears come out of their caves to announce the end of the bull. As interesting as a price trade below the 200-day might be, it is a misuse and misunderstanding of how to read such trading action.

As noted numerous times before, it is far less important when the current price trades below its 200-day moving average than it is if the 50-day moving average crosses the 200-day. And even that is not as important than if both the 50 and 200 day point in the opposite direction of the established trend, which in this case is up.

Then, and only then (price below moving averages, 50 day below 200 day, both 50 and 200 day pointing downward), do you have a trend reversal.

Again:

* Price below moving averages
* 50 day below 200 day
* 50 AND 200 day pointing down

Now to take this one step further, when seeking to identify a mega trend reversal, it would help if other key indices were also experiencing a similar such episode. For example, if the twins of the Dow Theory (Industrials and Transports) or the NASDAQ and the NASDAQ 100 or the Russell 2000 were in synch with the angst perhaps then an investor might suspect a mega trend reversal was in the works.

At present, aside from the Dow Transports (second chart), the other indices noted are either at a similar juncture (Dow Industrials, Russell 2000) or nowhere near such a potential turning point (NASDAQ (third chart) and NASDAQ 100).

One additional way to evaluate the potential of mega trend reversal is to view the three market cap segments – mega, mid, and small – to see if a mega trend reversal is at hand. Once again, the data says no trend reversal has occurred, although the small cap style is in the worse shape with the price 4% below its 200 day.

Lastly, let’s go global. Here’s a short list:

EAFE (EFA) – nowhere near
Europe 350 (IEV) – nowhere near
Emerging Markets (EEM) – nowhere near
Latin America 40 (ILF) – nowhere near
Japan (EWJ) – on the verge

Naturally, other reasons to be concerned exist in some of the above noted markets, specifically overbought levels in highly speculative markets like the emerging markets. However, overbought conditions in speculative, smaller markets, while likely to experience substantial market corrections, are not systemic threats to the global mega trends in place. Only a massive plunge in concert with a breakdown in developed markets would give cause for serious concern. That is not the case thus far.

Investment Strategy Implications

For the umpteenth time: It’s a bull market ‘til it ain’t.

The momentum lemmings may scare the bejesus out of some investors with days like yesterday. However, it is advisable to keep in mind that as swiftly as the pack runs for the hills so, too, do they race right back in the game when the money flows in an upward direction. (See yesterday’s blog for the latest comment re our little furry friends.)

My advice: Never lose sight of the fact that mega trends are what matters most first, foremost, and always. The call re a mega trend drives the single most important decision any investor needs to make: the Asset Allocation decision. From that point of view come the strategic and tactical decisions of where to allocate one’s assets and when to expand or contract current and prospective positions (what I call modified market timing).

The great value in technical analysis is keeping one in or out of the game when emotion, personal circumstances (a/k/a loss aversion), or fundamental logic dictate otherwise.

Investing is a dynamic, perpetual social science experiment that is both rational and irrational. Therefore, to the best of one's ability - Identify then Exploit the behavior.