Are Moving Averages A Useful Trading Guide?

Is the market trend up, down, or neutral? One of the most common ways to assess a trend is the moving average. But is the moving average a useful guide for trading decisions? I decided to take a look.

Since 2004 (N = 710 trading days), we've had 328 days in which the S&P 500 Index (SPY) has closed above both its five-day and twenty-day moving averages. Over the next ten days, SPY has averaged a loss of -.03% (182 up, 146 down).

Conversely, when SPY has closed below both its five-day and twenty-day moving averages (N = 200), the next ten days have averaged a gain of .72% (126 up, 74 down).

Indeed, just knowing where the S&P 500 Index has been trading relative to its 20-day moving average has been informative.

When we've closed above that moving average (N = 441), the next 20 days in SPY have averaged a gain of only .20% (261 up, 180 down). That's about a third of the average 20-day gain from 2004 to the present.

On the other hand, when we've closed below the 20 day MA (N = 269), the next 20 days in SPY have averaged an impressive gain of 1.24% (188 up, 81 down).

In short, knowing where we're trading relative to moving averages *has* provided us with useful trading information, but not in the way many technicians expect. Because of mean reversion, returns when we're trading above moving averages have been subnormal. Returns when we've been trading below moving averages have been superior.

The trend has indeed been your friend in the last few years in the large cap stock indices, but only if you've faded it.

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