Moving averages are useful tools in security analyses

Update: 1/11/21

In News by admin

Stocks: Time for a pause?

Moving averages (MAs) are useful tools in security analyses because they smooth out prices and thereby reduce noise. In this case, let’s use simple moving averages to help us look ‘inside’ an index and evaluate investor sentiment. If a security is trading above its moving average, it’s said to be trending upward, and vice-versa.

The chart below plots the price of the S&P 500 index (dark blue line) against the percentage of its component stocks that are trading above their respective 200-day MAs (light blue line). In other words, the light blue line shows the percentage of S&P 500 stocks in an uptrend. Currently, 92% are above their 200-day MAs – a historically high number.

As you can see, the chart very clearly shows that past instances where the percentage of stocks above their 200-day MAs falls below 10% (i.e. very few stocks are moving up) have been great times to buy. Late 2002, late 2008 and March 2020 jump off the page. Those occurrences are rare and they marked significant bottoms.



So, if very few stocks trending upwards is good news, does that mean very high numbers (like now) are bad news?  Probably not. Looking back to the 1990’s there have been 10 times when this number has been above 90%. Only one of them, (March of 2020) coincided with a significant top.

While this metric may not be a good tool for forecasting market tops, it is likely a good indicator of near-term underperformance. The average return one month after a 90% reading is only .06% — less than 1/10th of the average return following a +90% reading.  Trailing three and six month returns tend to be lower as well, though by not as much, coming in at just under one half and one third of the returns logged by their oversold counterparts.  So while there’s no need to fear anything dire happening soon,  it may be prudent to expect less than average returns in the near term.




Sincerely,

Jim, Mark, and Dave

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