- MACD is a technical indicator that can generate buy-and-sell signals.
- It is particularly useful in trending markets.
- Currently, MACD suggests US stocks may be relatively expensive on a short-term basis.
On August 18, the S&P 500 surpassed its pre-COVID-19 all-time high set on February 19, 2020. While many global economic data points remain concerning—including historically high unemployment and weak consumer spending—it’s been a steady climb back for US stocks since the March coronavirus-induced low. Recapturing the all-time highs has many wondering if the stocks will remain in an uptrend or if COVID-19 may stall the market's momentum.
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 relatively 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, or 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. The market has been trending higher for several months since the March low. 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 right hand Y axis of the bottom panel of the chart above. 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 relatively far away from the zero line), the signals would be as follows: When the MACD line is relatively 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 relatively 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. For comparison, MACD reached an extreme oversold reading (i.e., under negative 200) during the market selloff in March.
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 either cross above the zero line. The MACD line and signal line crossed above the zero line (a buy signal) in mid-April and stocks have rallied since 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. Given that there is not much difference between the MACD line and the signal line, the difference line is not suggesting a crossover is forthcoming.
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, the MACD and signal line would need to separate to some degree in order for a meaningful crossover signal to occur.
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 and higher lows since early July, suggesting the uptrend may continue (contrary to the other evidence provided by MACD).
Of course, this contradictory signal is another reason why 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.