Editor’s note: This article was first published in April 2014; the view of the S&P 500 as very overvalued, the IBEX 35 and Facebook support levels, and the reference to the biggest bull market so far, the 2009–2014 rally, all reflect that date. The three charts this article describes could not be recovered, and its April 2014 market calls are not investment advice.
No indicator is right 100% of the time, but when we decide to do trend trading, we have to be guided by probability and statistics. It is often said that traders should keep macro news separate from technical indicators, but the truth is that we can increase our probability of success if a technical indicator gives us an entry signal and that signal is backed up by the macro news, whether we are talking about a downtrend or an uptrend.
One of the indicators that has historically worked best is the moving average. I would go so far as to say that, even beyond trend trading, the moving average can give us the signal to build a long-term portfolio, as well as the signal to take profits and get out of the market. Of course, there are other indicators such as the RSI and the MACD (we will explain them in future articles), and by combining them we can increase that probability of success even further.
Let’s look at some examples from both the S&P 500 and the IBEX 35.
The first step in deciding which moving average to use is to go back through the price history of the index or stock and see which one has worked in the past. While the 200-session moving average has worked well for indices, with some stocks I have found that the 100-session average has worked better.
The 200-session moving average crossing the 50-session moving average
On this S&P 500 chart we can see how the 200-session moving average has been acting as support for the 50-session moving average. In 2008, we can see what happens when the 50-session MA (blue) crosses below the 200-session MA (orange). It triggered a very bearish trend in which the 200-session MA had now become resistance. (We can also read it as the 200-session average crossing above the 50-session average.)
Later, in mid-2009, we can see what happened when the blue line crossed above the orange line, setting off the biggest bull market the S&P 500 has had so far in its entire history.
Now people are saying that the S&P 500 is heavily overvalued and that the market has gone mad, because the trend, which is technically clearly bullish, does not match the fundamentals of companies, which are starting to show signs of slowing earnings. When will the severe correction we are expecting arrive?
I would venture that as soon as the blue line crosses back below the orange line, we will see that sharp correction we are waiting for. And the correction will probably be excessively severe.
The 200-session moving average on its own
This chart shows the history of the IBEX 35, where we can see how the 200-session moving average has worked almost perfectly as both support and resistance for the index.
After a long uptrend, the IBEX 35 ran into the 200-session MA several times, bouncing off it and carrying on with its uptrend. After a feint below the MA at the end of 2007, it climbed again.
Today we know that this was a trap for the bears and a con for the bulls who bought thinking the party would go on, and we can see what happened when the price finally fell below the 200-session MA: it triggered a strong downtrend in which the average now acted as resistance.
When the price broke out upwards, there was a strong rebound. Between 2010 and mid-2011 the moving average stopped being reliable, but the MACD worked perfectly (although, of course, we can only say that with hindsight).
The fact is that since the upward breakout in 2012, the 200-session MA has acted as support for the IBEX 35.
An example with Facebook
In the same way, with a stock like Facebook we can see how it began a big climb as soon as the moving averages crossed upwards (admittedly, along with a string of positive news). Right now, the 100-session moving average is acting as support for Facebook’s share price, a support that is currently in danger and that would get technically worse as soon as the blue line crosses below the orange line again.
Conclusions
Moving averages are fairly effective, though not free of false signals that could lead us into mistakes. We should also bear in mind (as you will have noticed) that if we wait for the averages to cross, we may miss out on a lot of the gains, because they are slow to cross. For example, in the case of the IBEX 35, the index fell as low as 5,900 points, whereas the entry point, had we followed this indicator alone, would have come at around 7,500 points. In other words, we would have missed much of the party.
Featured image: Mogrifier5, CC BY-SA 3.0, via Wikimedia Commons.
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