Not everyone understands the importance of physics. It is a complex and difficult subject to master. However, we see the law of physics applied to everything we do. It has a direct impact on all our lives – basically keeping us moving and grounding us to Earth (ground). For example, as we gain speed, we can jump higher despite the pull of gravity. However, as we lose speed and lose momentum, gravity will pull us back to Earth. So, the more speed we have, the further and the higher we can jump. Michael Jordan and Lebron James are great examples.
Prices and moving averages have a similar relationship to each other as humans have with Earth. Moving average is a great technical indicator because of its simplicity and its ability to be applied to various types of analysis. In the financial markets, when a stock price has momentum or speed, it can travel at a faster pace, at a steeper angle, and to higher prices above its key moving average (i.e., 50-day ma or 200-day ma). However, when the price travels to an extreme distance above its moving average it will begin to lose momentum as it returns back to the key moving average (ground).
So, how do we know when the trend will begin to reverse direction?
The two factors that can determine the start of a trend reversal: (1) the current angle of the price acceleration; and (2) the distance the price has moved from its key moving average (ground).
Historically, a sustainable uptrend will typically rise at a 30 to 45-degree angle. When the trend tilt toward 60 degrees or higher an impending reversal is likely to occur in the near future. The distance of the current price to its moving average is also critical to the sustainability of the rally. The greater the spread between the current price and a key moving average (200-day ma) the higher the risk for gravity to begin to reverse the existing trend. Although the price can continue to trend higher to even more extreme levels it cannot sustain at this pace and at this steep angle indefinitely.
While most investors and traders use moving averages for trend following purposes, they are also quite reliable as a mean reversion trading tool. Like the gravity concept, mean reversion occurs when the market has rallied too much and too far above its moving average then it will soon reverse direction and fall. Conversely, when the market has fallen too much and too far below its moving average it will soon rally. The distance from its moving average indicator quantitatively define when the price is trading too far from its moving average (i.e., 200-day ma). A contrarian trader will tend to buy when the market has fallen significantly below its 200-day ma and tend to sell when the market is trading significantly above its 200-day ma.
The recent March 2020 to present rally for SPX is now trading 7.27% above its 200-day ma. During early-2018 and February 2020 the distance above the 200-day ma (DMA) indicator reached a high of 13.93% and 11.70%, respectively. A convincing move above 7.35% or the Jun 2020 high can lead to SPX returning to the early-2018 and Feb 2020 highs. Does this imply an SPX target of 3,393.52 when the DMA indicator rally to 11.70%? And, will a DMA of 13.93% result in SPX recording new all-time price highs of 3,500-3,600?
Enclosed below are the charts of key US market indexes and the respective distance from the 200-day ma (DMA) indicators.
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