May 24

Moving Averages: Bull Market Still Strong

Posted by Kristjan Velbri | Posted in Markets | Posted on 24-05-2010

There has been quite a lot of talk about the major US indices trading below their 200 day moving averages. A large number of commentators who have brought it up have opined that this is the end of the cyclical bull market. It is important to note that some of those commentators have been bearish since the March 2009 lows. Sometimes it is difficult for humans to get past their ego (sense of being right/wrong), but in trading, there is no place for such at thing. I don’t have the numbers, but I would guess that a large number of bears who are pointing to the 200 SMA as a confirmation of the end of the cyclical bull are having problems with their ego. Most traders have had to fight tough battles with themselves over the psychological side of trading and chart reading, myself included. It is not my intention to make fun of chartists who are having problems with their egos, rather, I would like to point to a combination of moving averages that is better equipped at confirming the end of a cyclical bull market.

CLICK on charts to see them in full-size.

S&P 500 200 day movinga average

A simple chart with a 200 day SMA on it doesn’t really give us reason enough to doubt or confirm the end of a bull market. The arrows on the chart signify instances where the index has fallen below its 200 SMA (bull market false signals in green, bear market false signals in red).

S&P 500 50 & 200 day moving averages

Taking a look at the second chart, it is clear that the conventional combination of moving averages of the famous 50 & 200 SMAs is not good enough either. So what is an investor/trader to do? Take a look at the next chart.

S&P 500 60 & 260 day movinga averages

The third chart is equipped with exponential moving averages. Simple moving averages are just an arithmetic mean, each price is given equal weight. Exponential moving averages give more weight to recent data (see this for more). In addition, the value of today’s EMA is calculated using yesterday’s EMA, hence EMAs reflect price action from the inception of what is being measured. This last fact is important when choosing what charting service to use as not all chart software is made equal. More on that here.

As the explanations on the last chart make abundantly clear, it is not always wise to use technical indicators you heard mentioned on CNBC or read in a blog. I’m not saying the combination depicted on the last chart is the best, but it’s something that I found works way better than what is being offered by most commentators. My take on the charts is that we are still in a cyclical bull market as the fast EMA has not crossed below the slow EMA. Market breadth indicators (something that I’ll talk about sometime in the future) have been negative for quite some time now and past experience suggests we are at or very near the bottom of this correction. If, however, the EMAs mentioned above manage to make a crossover, we would be facing another bear market.

Note: The S&P 500 has been depicted in a lighter color on the second and third chart to make the MA crossovers visible.

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