- MACD is a technical indicator that can generate buy-and-sell signals.
- It is particularly useful in trending markets.
- Currently, MACD suggests stocks may be expensive on a short-term basis.
A decade beyond the nadir of the financial crisis, investors commemorated the 10-year birthday for the S&P 500's bull market in mid-March. This, after having their worst week of 2019 thus far.
International markets have also had somewhat of a sour tone lately, as the European Central Bank recently cut its growth forecast for the region and China announced some weaker-than-anticipated export data. Yet multiple global markets are still up double digits in 2019 on a total return basis, including the US—as measured by the S&P 500.
If stocks are still in a strong uptrend, active investors with short-term time frames may want to consider using MACD, in addition to other fundamental and technical methods, to evaluate the market. Currently, MACD as applied to the S&P 500 is registering an overbought signal, suggesting stocks may be expensive on a short-term basis.
How MACD works
The Moving Average Convergence-Divergence indicator, commonly known as MACD, is a technical indicator consisting of 2 lines—the MACD line and the signal line—as well as a bar chart. It is used to generate buy-and-sell signals, and to determine whether an investment or index may be overbought (i.e., potentially expensive) or oversold (i.e., potentially cheap).
MACD can be approximated by subtracting the value of a longer exponential moving average (EMA) from a shorter one. The shorter EMA is constantly converging toward, and diverging away from, the longer EMA. This causes MACD to oscillate around the zero level.* A signal line is created with an EMA of the MACD line. See the chart below for a sense of what MACD looks like.
MACD is a momentum oscillator that is generally best employed in trending markets—where prices are trending in a particular direction. If you are considering MACD, you should make a determination as to the trend of the market.
Short-term buy-and-sell signals are generated by the MACD line and the signal line. These 2 lines fluctuate around the zero line, which is found on the y axis on the right side of the chart. The zero line is also significant because it can act as support and resistance.
Oscillators like MACD are generally most valuable when their value reaches extremes of its boundaries. However, MACD can theoretically rise or fall indefinitely. If you were to apply relative extremes to the MACD indicator (i.e., the MACD and signal lines are far away from the zero line), the signals would be as follows: when the MACD line is well below the zero line in extremely negative territory, it can suggest an investment may be oversold (i.e., a buy signal). Alternatively, when MACD is well above the zero line in extremely positive territory, it can suggest an investment may be overbought (i.e., a sell signal). Currently, the MACD line and signal line are both above the zero line, suggesting stocks are expensive. However, they are not at an extreme overbought reading.
In regards to the zero line, a sell signal is given when the signal line or the MACD line crosses below the zero line, and a buy signal is given when they cross above the zero line. The MACD line and signal line crossed above the zero line (a buy signal) in January and stocks rallied for several weeks after that signal.
The difference line, represented in the chart above by the blue bars, is typically presented as a bar chart around the zero line. This bar chart represents the difference between the MACD line and the signal line, and is designed to help depict when a crossover may take place. Recall that a crossover generates buy and sell signals. A narrowing of the difference line (i.e., when the bars decrease) illustrates the potential for a crossover.
These signal line crossovers, as opposed to zero line crossovers, are typically the more frequent action many traders look for when using MACD. A buy signal is generated when the MACD line crosses above the signal line, and a sell signal is generated when the MACD line crosses below the signal line. As the chart above illustrates, a sell crossover signal occurred in late February. The next possible signal line crossover would be a buy sign (the MACD line crossing above the signal line).
Confirming the trend
Timing is everything
Choosing the time frame is very important as it can impact the look of the MACD chart, and potentially the interpretation and timing of signals. Experience using the MACD can help you determine the appropriate window, and it may be necessary to use multiple time frames to confirm your analysis.
One technique that technical analysts may use to confirm the direction of the trend is to determine whether the MACD indicator is making higher highs or lower lows in conjunction with the price. Many traders wait for a "trigger," or some sort of confirmation of the divergence. Both the S&P 500 and MACD lines had been making higher highs until the recent market weakness and rounding top pattern for the MACD lines.
Of course, you should never use a technical indicator in isolation. Instead, it can be one of many tools you use to evaluate the market or an investment opportunity. With the market potentially back in a trading range, indicators like MACD may be particularly helpful for short-term investors.