Thursday, February 14, 2008

Technical Thursdays: Moving Averages Principle – A Valentine's Day Gift

As time passes, an increasing value can be found in the Moving Averages Principle (MAP) that I developed over the past several years. In today’s edition, let’s illustrate by looking at three distinct slices of the equity markets in two distinct MAP phases – Latin America 40 (ILF), Financials (XLF), and Small Cap style (IJR).

In the first chart (ILF)*, you can see how price is currently above both moving averages (50 and 200 day), that the 50 day has not crossed the 200 day, and that the 200 day slope is upward. These are the three key components of the MAP – price in relation to moving averages, moving averages in relation to each other, and the slope of the moving averages (particularly the slope of the 200 day).

Note how price did cross both the 50 and 200 day on numerous and several occasions, respectively, over the past two years. Yet, at no time did the three components of MAP occur. The bullish mega trend is intact. Now, contrast this data with our second chart – Financials.

The XLF chart shows price crossing the 50 day moving average on many occasions and the 200 day several times. However, it wasn’t until late summer/early fall last year that all three MAP conditions were met for a mega trend reversal call to be made.

The third chart (IJR) shows the same pattern as the Financials.

Investment Strategy Implications

The Moving Averages Principle takes the base form of moving averages analysis to another, more effective level. By going beyond the tried but not quite true method of declaring a stock in a mega trend change whenever it crosses just one of its major moving averages (most notably the 200 day), the MAP produces far less false signals.

A few points to remember re the MAP:

The application of the MAP applies most effectively to overall markets/regions, sectors, and styles. However, the application of the MAP is somewhat less effective when it comes to industries and even less effective when applied to individual stocks. The reason for this reduced effectiveness apparently pertains to the fact that the closer you get to those areas of the economy that are subject to more issue specific factors, the higher the odds are of any market-based tool generating false signals.

Additionally, at no time does the MAP negate the need for judgment. For example, there are times when effective tools like the MAP will be on the cusp of producing a mega trend change signal requiring judgment (including bringing into consideration other factors, such as a fundamental view).

While no tool is foolproof, the MAP has demonstrated its usefulness many more times than not. And certainly far better than the basic crossing of a moving average.

To learn more about the MAP, see prior blog postings under the topics discussed segment of this blog – Moving Averages Principles.

*click images to enlarge
Note: Accounts managed by Blue Marble Research own positions in ILF and XLF.
Neither Vinny Catalano nor any member of his family own positions in any of the above issues.

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