Distance from Moving Average Indicator
Updated: Aug 26, 2022
The summer rally has stalled in stock market indexes, including the large-cap S&P 500 Index (SPX). With the impending seasonal weakness period from September to October and the uncertainties of mid-term elections, will stocks suffer another selloff?
Fundamental Analysts value securities by evaluating financial ratios such as Price Earnings (PE) and Earnings Per Share (EPS).
Technicians use technical indicators such as moving averages to help determine the extent of a rally. One popular technical indicator is the distance from the moving average (DMA), which measures the distance (in percentage) above or below security from its key moving average (i.e., 50-day or 200-day). The objective is to determine the sustainability and momentum of a price trend.
Moving averages are lagging indicators but are most useful as they remove the noise and fluctuations in the market. They identify the strength of a trend rather than predicting the movements.
The distance from the moving average indicator (DMA) can be an effective indicator: (1) Determine the primary trend (uptrend, downtrend, sideways trading range). (2) Identify an overbought or oversold condition. (3) Signal an impending retracement, reversal, or continuation trend.
Since moving averages are lagging indicators, some believe it is useless. Yes, moving averages lag, but when deployed with other technical indicators are powerful (i.e., MACD and RSI) and different technical disciplines (i.e., pattern recognition analysis, trendline analysis, price breakout projections, Fibonacci retracement, etc.).
Enclosed are charts of popular market indexes, including SPX, INDU, NYA, COMPQ, NDX, MID, and SML, and their respective distance from 50-day ma and 200-day ma.
Interestingly, the popular indexes all show similar technical conditions, including the following: (1) All are trading below their primary downtrends. (2) Trading below their 200-day moving averages. (3) Trading above their 50-day moving averages. (4) The distance from the 50-day moving averages is positive, and the distance from the 200-day moving averages is negative. (5) The 200-day ma is falling, and the 50-day ma is rising.
So, what does this all mean?
The contraction in the 200-day and the 50-day moving averages warns of another inflection point. The outcome of the convergence between the two key moving averages will help determine the next directional trend.
There are several market outcomes:
Scenario 1: If the index successfully tests and rebounds from its 50-day ma, this is a bullish condition that extends the summer rally into early fall.
Scenario 2: If the rising 50-day ma successfully crosses above the 200-day ma, a golden cross buy signal occurs. The bullish development reaffirms the mid-Jun 2022 low as the bottom and signals a sustainable rally to retest the all-time high.
Scenario 3: If the index convincingly breakdown below its 50-day ma, this is moderately bearish as it warns of a retest of the Jun/Jul 2022 lows.
Scenario 4: If the rising 50-day ma rallies to the declining 200-day ma and falters and rollover (downtrend), this is extremely bearish, confirming a market top and the start of a rolling bear market.
Scenario 5: A neutral sideways trading range occurs as the indexes whipsaw between pivotal support, coinciding with the rising 50-day ma, and critical resistance, corresponding to the declining 200-day ma and primary downtrend.