- MACD is a technical indicator that can generate buy-and-sell signals.
- It is particularly useful in trending markets.
- Amid the rally to record highs for US stocks, MACD is not sending a strong signal for short-term market direction. But that could quickly change.
The S&P 500 reached another all-time high this week, despite more pandemic worries as the Delta variant has increased new COVID-19 cases and associated hospitalizations around the world. The US and other economies continue to generate mostly strong corporate earnings growth, and there are expectations for significant government spending to sustain growth. These factors, along with the Federal Reserve announcing intentions to reduce its monthly asset purchases this year, some perceptions that stocks are broadly overvalued at these record levels, and other risks, appear to be helping bulls overpower COVID fears.
Given these competing dynamics, active investors that are wondering if the momentum will continue over the short term may want to consider using the MACD technical indicator, in addition to other fundamental and technical methods, to evaluate the market. Currently, MACD as applied to US stocks is registering a weak signal, suggesting caution over the short-term.
How MACD works
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.
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). See the bottom section of 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 might first consider determining the trend of the market. As the top section of the chart below shows, the market has been trending higher since the March 2020 low.
Short-term buy-and-sell signals are generated by the MACD line and the signal line. If the MACD line crosses above the signal line, this may be interpreted as a buy signal. Alternatively, if the MACD line crosses below the signal line, this may be interpreted as a sell signal. These 2 lines fluctuate around the zero line, which is labeled on the right-hand Y axis of the bottom panel of the chart above. 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 zero line is also significant because it can act as support and resistance.
Oscillators like MACD are generally most valuable when they reach their boundary's extreme levels. 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).
What MACD says about stocks now
Currently, the MACD line and signal line are both above the zero line, suggesting stocks may be overbought (i.e., a bearish signal). However, they are not at extreme overbought readings, which makes for a relatively weaker signal given by MACD. For comparison, MACD reached an extreme oversold reading (i.e., under negative 20) in the fall of 2020 and have rallied significantly since then. The MACD line and signal line crossed above the zero line (a buy signal) in early November 2020 and stocks have rallied since that signal. The next possible signal here would be the MACD and signal lines crossing below the zero line, a bearish 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.
The next crossover between the MACD and signal line would be a bullish signal, following the bearish crossover that occurred on August 17. It is worth noting that, within the context of this indicator, these crossover signals occur quite frequently, are viewed as a very short-term signal, and should not be interpreted as being as significant as longer-term crossover signals.
Confirming the trend
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. Some traders that utilize this strategy wait for a "trigger," or some sort of confirmation of the divergence. Only the S&P 500 has been making higher highs and higher lows since early July, indicating no clear trend from this signal.
In sum, the various signals generated by MACD appear not to be all that clear—with some being conflicting. This potentially suggests short-term caution may be warranted, according to this indicator. Of course, real world events—especially developments with the Delta variant and the outcome of negotiations on infrastructure and reconciliation packages—will drive markets over chart patterns. Indeed, you should never use a technical indicator in isolation. With that said, indicators like MACD can be one of many tools you use to evaluate market trends.