Saturday, August 26, 2006

Do Moving Averages Matter?

You generally don't have to go very far in the trading world before hearing some guru expound upon the fact that a stock or index is trading above or below a moving average, crossing a moving average, or seeing its short-term average cross its long-term average. Do moving averages really make a difference?

I decided to take a preliminary look. I went back to 1950 in the S&P 500 Index (N = 14,290 trading days) and examined all days in which the $SPX was either above or below its 50-day moving average. This seemed like an appropriate time-frame for an intermediate-term trader.

Over that time, we had 9044 occasions in which the S&P was above its moving average and 5246 occasions in which we traded below the moving average. When the $SPX was above the moving average, the next 50 days in $SPX averaged a gain of 1.65% (5745 up, 3299 down). When $SPX was below the moving average, the next 50 days in $SPX averaged a gain of 1.85% (3328 up, 1918 down). The moving average did not appear to have a significant impact on future price change.

What *is* evident is the obvious: In bull markets, such as from 1995-1999, it paid to be bullish when the market was above its 50-day moving average. In bear markets, such as from 2000-2002, that was a losing strategy for bulls. Since 2003, buying dips below the 50-day MA has been quite profitable. In 2001-2002, that strategy was suicidal.

During most of 2006, buying above the 50 day MA has been a losing strategy; buying dips below the 50 day MA has, on balance, made money.

One way of summarizing all of this is that the behavior of $SPX around its moving average is more descriptive than predictive. It gives us a broad sense of the rules that the market is following at the time--which is not at all a worthless piece of information. At present, we are trading over 2% above our 50-day MA. If we assume that the market's recent rules will carry forward into the near future--a critical assumption, and one that is not always correct--this should not be a time to be adding to positions.

One other observation: If we focus on the percentage that we are above or below the moving average, some interesting findings emerge. At the upper group of outliers--instances in which $SPX has traded more than 10% above its MA--we see dates such as 1975, 1982, 1991, and 1998 well represented. In almost every single case (N = 59), the S&P was up 50 days later. Thrusts *much* above a moving average appear to have different expectations than normal rises above the benchmark. When $SPX is more than 5% above its 50-day MA (N = 1394), the next 50 days are up by an average 2.46% (985 up, 409 down). That starts to look more like a meaningful bullish edge.

Conversely, when we see $SPX more than 10% below its 50-day MA (N = 160), we see such dates as 1962, 1970, 1974, 1981, 1990, and 2002. Those represented important cyclical bottom regions in the market. Fifty days later, the market was up on average by nearly 5%, with winners outnumbering losers well over 3:1. Indeed, returns are superior on average when the market has been more than 5% below its 50-day moving average.

What that means is that returns are bullish when we've been 5% or more above the 50-day MA and when we've been 5% or more below the 50-day MA. Strong upthrusts have tended to continue into the next time period, and strong downthrusts have tended to reverse.

And when $SPX has been hugging its MA, within 2% above or below its 50-day line (N = 6035)? We see no bullish edge over the broad sample, with an average 50-day gain of 1.38% (3773 up, 2262 down). That is slightly below the average 50-day price change of 1.72% for the entire sample.

Just knowing if we're above or below a moving average or whether we're crossing a MA appears to be less important than the *degree* to which we're above or below that average. The bullish edge appears to occur at the extremes of market trajectory. I suspect that this principle might hold true over multiple time frames, creating possible edges for short-term traders as well as investors. More on that tomorrow, drawing upon indicators from the Trading Psychology Weblog.