Navigating Complex Markets

As a stock trader, I was trained to pay attention to moving averages, particularly the 200-day average. The traditional thinking is that when the current market price crosses the moving average price, it is an indicator on the directional trend of the security. For example, a trader watching a stock sell off and fall below its moving average would typically view this signal as bearish. With today’s correction in the US stock market, there is increased chatter about moving averages, specifically whether or not a stock is trading above or below its moving average and what this simple metric suggests about future direction. I think it is worthwhile to understand if these signals are valid or not.

For background, a moving average is calculated by a simple sum of the market prices for a specific period of time divided by the number of days in question. Thus, the common 200 day moving average is an average of market prices going back 200 trading days. As each trading day passes, the average is re-computed, dropping off the oldest price point and replacing it with that from the prior trading day.

A historical review, conducted by Hulbert Ratings, considered a binary approach of holding equities when they are above their 50- and 200-day moving average (thought to be a bullish signal), and conversely holding 90-day T-bills when equities were below their moving average (a bearish signal). Their historical analysis discovered that this strategy worked extremely well from 1926 until the 1990’s. So well, in fact, that it has been anchored into our minds. And I can attest that they were teaching these theories when I started trading in the late 90’s.

Curiously, data since the 1990’s suggests that moving averages are no longer useful. Since the 90’s, reliance upon moving averages as a bull/bear signal has had the oppositive effect. The simple fact that a stock is trading above its 50- or 200-day moving average is no longer a clear bullish signal. So, what changed in the 90’s?

Professor Blake LeBaron from Brandeis University has theorized that the lower trading costs and barriers to trading are the reason why these signals do not seem to work. Easier and low cost access to markets enabled more active trading, thereby empowering more investors and traders to chase these signals than was previously possible. Commissions began falling after May Day in 1975 when US stock markets were deregulated. Cheap and broad exposure was increasingly available through ETFs and index funds. And bid/ask spreads have shrunk markedly.

The lesson here is that moving averages seem to matter less than we may believe. As volatility increases, you are likely to hear more about which stocks or broad indices are breaking above or below their moving average. And some market observers will jump to bullish or bearish conclusions from these signals. The reality is more complex, as markets are so much more accessible that any advantage from these simple signals seems to have evaporated.

Meet Your Expert

Grant Johnsey

Grant is responsible for delivering capital market solutions to institutional clients across agency brokerage, transition management, security finance, and foreign exchange.

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