Those cries of anguish you’re hearing are from technicians lamenting the Dow Jones Industrial Average breaking the 200-day moving average in Monday’s losing session.
Don’t get caught up in their hysteria. In fact, a shrewd contrarian bet might even be to consider that break as a buy signal.
200-day moving average has for decades been used as technical confirmation of the U.S. stock market’s major trend. Numerous technical analysts consider the major trend to be down whenever the market breaks below its average level of the previous 200 trading sessions.
That’s what happened on Monday. Going into the trading session, the Dow’s 200-day moving average stood at 24,281.66, according to FactSet; it closed the session at 24,252.80, some 29 points below it. The S&P 500
, however, remained slightly above its 200-day moving average of 2,664.39.
One reason to avoid reacting in a knee-jerk way is to reflect on what happened the last time the 200-day moving average was broken on the downside, in early February. In the wake of that break, the market rallied strongly.
Nor is that experience particularly unusual. Over the past 25 years, in fact, the Dow has performed slightly better after a 200-day moving average sell signal than it has on average following all other days — as you can see from the accompanying chart. (For the purposes of this chart, I considered a sell signal to have occurred whenever the Dow was above its 200-day moving average on a given day and then closed below it on the subsequent day.)
You read that right. You would have made more money over the last 25 years by treating the breaking of the 200-day moving average as a reason to increase stock exposure rather than reduce it.
I chose to focus on the last 25 years because research from Brandeis University finance professor Blake LeBaron has found that moving averages became markedly less effective in the early 1990s. LeBaron tells me that we can only speculate as to what happened then that caused their diminished effectiveness. But since he has also found that moving averages stopped working at about the same time in the foreign currency markets, we can be fairly confident that whatever happened was more than just a random fluke.
To be sure, the 200-day moving average did have a better record in the earlier part of the last century than over the last 25 years. But even in those earlier years it still left much to be desired — as I discussed in some detail in my February column in the wake of that month’s break of the 200-day moving average.
None of this discussion amounts to a guarantee that the market will now rebound, of course. There are plenty of reasons for worry other than the break of the 200-day moving average. But the burden of proof is on followers of the 200-day moving average to show us why, in contrast to the last 25 years’ average, this week’s break of the moving average will be the beginning of a major downtrend.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email email@example.com .