Even though several global markets are near or at all-time highs, as of late April 2019, there are reasons to be cautious about stocks right now. These include:
- Geopolitical risks. Trade wars, Brexit, and looming elections linger as likely trade risks.
- Earnings expectations. The bar may become particularly high for year-over-year comparable earnings expectations in the wake of the tax cut that went into effect last year. The estimated earnings decline heading into the Q1 reporting period was 4%, according to FactSet.
- An aging business cycle. The US is firmly in the late stage of the business cycle amid uneven global growth.
However, there are also reasons to be optimistic, and one chart signal suggests there may be bullish technical momentum. Recently, a “golden cross” moving average crossover signal occurred for the S&P 500—a bullish indicator that says stocks will rally (see Moving averages for the S&P 500).
As a supplement to your fundamental analysis of an investment opportunity, or to add insight to an investment you already own, here’s how you can incorporate moving averages to potentially enhance your trading proficiency—and what they may be signaling about the US stock market now.
What are moving averages?
Among all the technical analysis tools at your disposal, moving averages are one of the easiest to understand and use in your strategy. Moving averages may be a particularly useful tool to help you see through the noise and identify trends as they are unfolding.
A mean is simply the average of a set of numbers. A moving average is a (time) series of means; it's a "moving" average because as new prices are made, the older data is dropped and the newest data replaces it.
A stock or other financial security's normal movements can sometimes be volatile, gyrating up or down, which can make it somewhat difficult to assess if there is a pattern forming in its general direction. The primary purpose of moving averages is to smooth out the data you're reviewing to help get a clearer sense of the trend.
There are a few different types of moving averages that investors commonly use.
- Simple moving average (SMA). An SMA is calculated by adding all the data for a specific time period and dividing the total by the number of days. If XYZ stock closed at 30, 31, 30, 29, and 30 over the last 5 days, the 5-day simple moving average would be 30 [(30+31+30+29+30)/5].
- Exponential moving average (EMA). Also known as a weighted moving average, an EMA assigns greater weight to the most recent data. Many traders prefer using EMAs because they place more emphasis on the most recent market developments.
- Centered moving average. Also known as a triangular moving average, a centered moving average takes price and time into account by placing the most weight in the middle of the series. This is the least commonly used type of moving average.
Fast and slow
Shorter moving averages are frequently referred to as "fast" because they change direction on the chart more quickly than a longer moving average. Alternatively, longer moving averages can be referred to as "slow."
Moving averages can be implemented on all types of price charts (i.e., line, bar, and candlestick), and are also an important component of other technical indicators. In terms of when to use moving averages, they can be helpful at any time. However, they are considered to be particularly useful in upward (or downward) trending markets—like the long-term uptrend we have been experiencing since 2009. Of course, trends can be broken at any time, and there is no guarantee that the market is still in an uptrend.
When setting up your charts, adding moving averages is very easy. In Fidelity's Active Trader Pro®, for example, simply open a chart and select "Indicators" from the main menu. Search for or navigate to moving averages, and select the one you would like added to the chart.
You can choose between different moving average indicators, including a simple or an exponential moving average. You can also choose the length of time for the moving average. A commonly used setting is to apply a 50-day exponential moving average and a 200-day exponential moving average to a price chart.
Moving averages in action
Moving averages with different time frames can provide a variety of information. A longer moving average (such as a 200-day EMA) can serve as a valuable smoothing device when you are trying to assess long-term trends.
A shorter moving average, such as a 50-day moving average, will more closely follow the recent price action, and therefore is frequently used to assess short-term patterns. Each moving average can serve as a support and resistance indicator, and each is also frequently used as a short-term price target or key level.
How exactly do moving averages generate trading signals? Moving averages are widely recognized by many traders as potentially significant support and resistance price levels. If the price is above a moving average, it can serve as a strong support level—meaning if the stock does decline, the price might have a more difficult time falling below the moving average price level. Alternatively, if the price is below a moving average, it can serve as a strong resistance level—meaning if the stock were to increase, the price might struggle to rise above the moving average.
As the S&P 500 chart above shows, US stocks are currently trading above their 50-day (red line) and 200-day (blue line) EMA, both of which may act as support for stocks over the short term. A decline below these moving averages would be interpreted as a negative trading signal. The S&P 500 climbed above both moving averages (a bullish signal) in the first 2 months of the year.
The S&P 500 used the 200-day EMA as support in March, and promptly rallied over the next several days in advance of the golden cross trading signal (more on this shortly). In fact, the 200-day EMA has been an important trading level over the past 6 months. You can see that in late 2018, the 200-day EMA served as a resistance level 3 consecutive times (the S&P 500 was able to rise above it, but not hold above for long), and stocks eventually succumbed to weakness at the close of the year. Consequently, technical analysts might see stocks break above the 200-day EMA in early 2019, and the ability to hold above this level, as an additional sign of bullish chart strength.
The golden cross and the death cross
Two moving averages can also be used in combination to generate what is perceived by many traders as a powerful "crossover" trading signal. The crossover method involves buying or selling when a shorter moving average crosses a longer moving average.
A buy signal is generated when a short moving average crosses above a long moving average. For example, the "golden cross" occurs when a moving average, like the 50-day exponential moving average, crosses above a 200-day moving average. This signal can be generated on an individual stock or on a broad market index, like the S&P 500. The last crossover was a golden cross in early April. The S&P 500 has rallied since then. This crossover signal does not typically occur often, and so particular credibility is given to it in the eyes of technical analysts.
Alternatively, a sell signal is generated when a short moving average crosses below a long moving average. This "death cross" would occur if a 50-day moving average crossed below a 200-day moving average. The last death cross occurred in December 2018, when stocks plummeted into year end. The next possible crossover signal, given that the last one was a golden cross, is a death cross.
Of course, a golden cross or a death cross do not suggest that you should mechanically buy or sell. Remember, indicators like moving averages can generate signals that you may not want to act upon, depending on your strategy. There have been several crossovers by the 50-day and 200-day moving averages over the past several years, and trading these signals may not have aligned with your objectives. Rather, these crossovers are an additional piece of information that may suggest a change in the trend.
A few final tips
As a general rule, recall that moving averages are typically most useful during uptrends or downtrends, and are considered least useful during sideways, non-trending markets. Generally speaking, stocks have been in a staircase-like uptrend for most of the more than 9-year bull rally, so this general theory suggests that moving averages may be particularly powerful tools in the current market environment—if the market is indeed trending.
Also, it's worth noting that it is possible for the price to remain above (or below) a moving average for an extended period of time, as the chart above demonstrates. Moving averages can give frequent, and sometimes conflicting, trading signals. It's up to you to determine which signals you consider significant. Moreover, these signals should never be acted upon in isolation.
Finally, you would not want to trade solely based on the signals generated by moving averages. Each investment opportunity should be evaluated on its own merit, including how it aligns with your investment objectives, risk preferences, financial circumstances, and investing time frame.
Moving averages can be used in combination with other technical and fundamental data points to help form your outlook on an individual stock and on the overall stock market.
Next steps to consider
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