The 200-day moving averages (calculated by averaging the closing prices for the past 200 days) are plotted daily for many individual stocks, indexes and market averages, including the Dow Jones Industrial Average (DJIA), S&P 500 and the New York Stock Exchange Composite Index. Many financial newspapers print graphs which include the 200-day moving average for the most well-known averages and indexes. In addition, there are a number of chart and graph services that plot the 200-day moving average for individual stocks.
The 200-day moving average of a stock or an index is a long-term trend indicator that smooths out choppy day-to-day price activity and clarifies market’s direction. It is most useful for longer-term investors. Many shorter-term moving averages are also tracked closely by analysts. The most basic rule of thumb in working with any moving average (50-day, 100-day, etc.) is that if a price average or index is moving decisively above or below its 200-day moving average line, it will more often than not act as buy or sell signal.
Moving averages fall in the category of “mechanical” technical tools. The two other major areas of analysis are psychological indicators (or market sentiment data) and fundamentals, which relates to such factors as the economy, interest rates, earnings, etc. Many analysts combine all three techniques.
The first step in analyzing a moving average is determining whether a market average or index – such as the DJIA or S&P 500 – is above or below its moving average line. When an index moves above the line, it’s positive. When it moves below it, it’s negative.
It is also important to remember that moving averages are just one of many tools that technical analysts use to gauge market conditions. You have to be very careful in taking just one indicator and basing your entire market outlook on it. A combination of technical is much better than using only one.
Watching for divergences between key market indexes and their moving averages can be helpful. When the major market indexes are above their 200-day moving averages and one suddenly drops below it, the other market averages will most often follow.
Additionally, investors should also keep an eye on the slope of the moving average line. It is generally positive if the average is rising sharply and the index is well above it. If the moving average is essentially flat and market index is above it that is also considered positive. However it is not as good as having the moving average rising with the index above it. The worst is if the index is below a sharply declining moving average.
Take particular notice when an index violates its moving average after being above or below it for a long time. That is usually a sign of change in the trend for the market. If an index is above its moving average for a long time and then breaks below it, that means the market could be topping out. On the other hand, if it is below the moving average for a long time and finally edges above it that usually means the market is ready to change direction and go up.
As always, investors must put any technical patterns in the context of their fundamental views on the market and individual stocks. If you are bullish on the market fundamentals and are under invested and you see a segment of the market you are interested in move above its moving average on heavy volume that technical condition, combined with a positive fundamental view, should be a “buy signal.” Conversely, if your view of a fundamental picture is negative you might just watch the market more closely at that point to see if in fact the penetration of the average on the upside is significant. If the index continues higher, it may be a good time to rethink your market view. If your view is bearish and the market cuts below its moving average, it’s a loud sell signal. If you are bullish, caution may be in order.
While some of this is confusing, remember this is a financial column and not a course on technical analysis. My job here is to give you a taste of the different tools used to help gain insight into world of investing. Remember, moving averages, like all indicators, are not infallible. There are times when an index will whipsaw back and forth through its moving average. As always, use caution and make sure you understand what tools you are using and why you are using them.
Quote of the Week: “Eating words has never given me indigestion.” — Winston Churchill
Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.