Updated: Mar 13, 2020
Moving averages is a widely used technical indicator that helps smooth out the price action by filtering out the fluctuations of price moves. This is one of the core indicators and by far the most popular of all trend-following indicators. Remember this indicator is a lagging indicator as it is based on past prices. The longer the time period for the moving average, the greater the lagging tendencies. That is, 200-day ma will have a greater degree of lag than a 50-day ma simply because the prices contain 200 days versus 50 days. Moving averages with shorter time periods will respond faster to price changes than longer time periods. This may be great for traders, but it may generate too many signals and not applicable for longer-term investors.
Predicting trends in securities are the hallmark of the technical analysis discipline. It not an easy task and accurately forecasting a pivotal trend change is even more difficult to predict. There are two important variables to select when deploying moving averages including the length of the averages (i.e., 50-periods, 150-periods, 200-periods etc.) and the timeframe (intra-day, daily, weekly ma, monthly data). Like other trend following indicators, it is recommended to test which one works best for your specific investment time horizon (i.e., short-term trader, medium-term trader, investor, and long-term investor).
Moving averages are currently deployed by many traders and investors for a variety of different purposes. When deployed correctly it can help to predict trends and trend reversals. However, when used incorrectly it may lead to many false technical signals. Again, it is imperative to try to utilize the correct periods and timeframes that best match your investment horizon. You would not want to deploy a 10-day ma or a 30-day ma if you are investing. Nor would you want to deploy a 10-mo ma or a 30-mo ma if you are trading.
With the sharp decline in the stock market over the past few weeks there are many market pundits calling for the end to one of the strongest and longest structural bull markets in recent memories. With so much information, how do we know who is worth listening to and most, important who is remotely correct with their forecasts? Since, market trends reflect the collectively actions of all participants involved in the marketplace based on a given point in time, we will let the market trend decide who is ultimately correct with their forecast. So, if one wishes to understand the long-term trends or the structural trends of a market, then it is best to focus on the monthly data.
It is interesting that since 1980, the 40-month moving average have been uncanny in helping to uncover the structural trends of SPX. That is, once SPX convincingly breach its 40-month ma it has led to bear market declines (i.e., 2000-2002 and 2007-2009 bear markets) and vice versa, when SPX maintains above its 40-mo ma it has led to the resumption of the structural bull.
SPX is nearing another major inflection point as it is now trading just 20-points above its 40-month ma (2,721). A convincing break of this monthly moving average coupled with repeated failures to trade solidly above this moving average on subsequent rallies would mark an end to the current structural bull. This is commonly referred to as rolling the moving averages which often occurs when a major trend reversal develops.
However, it is also important to recognize the ability of SPX to maintain above this key moving average may help to contain the current deep/severe correction (20% decline) leading to another rally. The quality of the ensuing rally will help decide if this is an oversold rally or if this is another correction, albeit a severe one, within the content of a structural bull trend. Note that a convincing move above its Sep 2018 monthly close of 2,914 would help to solidify a bottom signaling a retest of its monthly close of 3,231.