The 200-Day Moving Average
As I continue to receive questions about the direction of the stock market, it seems that many investors are in awe of the rapid move downward in 2008 followed by the rapid move upward in 2009. It would seem that although the economy is going through a difficult time, it probably wasn’t really as bad as we thought it was last year; and, it probably isn’t as good as we think it is this year.
In the short run, the market is a voting mechanism where the next voter (or trader) can push the market up or down depending on the direction and size of the trade. In the long run, the stock market is a measuring tool that reflects the profitability, predictability and growth prospects of the underlying company as represented by the share price.
Technical analysis tends to measure the emotions of the next marginal trade and attempts to identify direction and magnitude without regard for company profitability, predictability and growth. Fundamental analysts tend to believe that the technical movements of a market are emotional driven, inherently volatile and ultimately simple random noise.
In the last two years, it is hard to argue that the short-term technical movements in stocks were simply driven by the emotions of the marginal trader. Similarly, it is difficult to argue that changes in company profitability could change as quickly as the market has seemed to believe that it has.
While day-to-day “noise” in the stock market is impossible to predict, the long-term fundamentals can’t account for the rapid changes we have seen in the stock market averages. One technical indicator that is helpful for fundamental analysts is the market’s 200-day moving average.
The 200-day moving average is a long-term trend view of the direction of the overall stock market. It measures the average market price over the last 200 trading days. The reason people use the 200-day moving average is simply because a large number of technical analysts use it, that it begins to have merit.
The 200-day moving average is best used as an indicator of times when the market has trended to either an abnormally high level or an abnormally low level. For example, on November 20, 2008 the S&P 500 was trading more than 32% below its 200 day moving average.
As the market digested what had happened in the economy and the marketplace this would have been an attractive time to begin accumulating stock market positions. Historically the market has rarely traded more than 30% below it’s 200-day moving average—twice during the 1930’s and once during the 1970’s.
Conversely, the stock market has rarely traded more than 20% above the 200-day moving average. The reason for the bias is that the market is generally more orderly on the way up than it is on the way down. At one point in the early 1980’s the market did trade higher than 120% of the 200-day moving average—however, it was quickly reigned in.
Today, the stock market (as measured by the S&P 500) is trading 19% above its 200-day moving average—a range we have rarely seen. For those of you who like to pick tops and bottoms, perhaps this is interesting.
For those of us who manage investment risk, this is clearly a time where the market should pause and evaluate the fundamentals.
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