One look at the S&P 500® Index shows that the long-term trend has been solidly up (see the chart right). There have been a few bumps in the road, including this month, in which stocks are down more than 2% as of August 20, 2013. But since March 9, 2009 the S&P 500 is up a whopping 172%.
With stocks appearing to have slowed somewhat in recent weeks, after setting fresh all-time highs in early August, could the market be entering a trading range? If so, the Moving Average Convergence-Divergence indicator, commonly known as the MACD, may help you decide if stocks might go higher, or if the risk of a sustained correction is mounting.
How the MACD indicator works
The MACD is a technical indicator that is used to generate buy-and-sell signals, and to determine whether a security or index may be overbought (potentially expensive) or oversold (potentially cheap). It is a momentum oscillator that is generally most useful in non-trending markets—where prices fluctuate in a range.
Buy-and-sell signals are generated by two lines: the MACD line and the signal line (see the chart below for a sense of what the MACD looks like). These two lines fluctuate around the zero line which is found on the y axis on the right side of the chart. The zero line is significant because it can act as support and resistance.
The difference line, shown in the chart above in green, 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. 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.
Oscillators like the MACD are generally most valuable when their value reaches the extremes of its boundaries (i.e., the MACD and signal lines are far away from the zero line). Consequently, when the MACD is well below the zero line in extremely negative territory—as it was near the bottom of the financial crisis—it can suggest that the market may be oversold. Alternatively, when the MACD is well above the zero line in extremely positive territory—as it was in early 2008—it can suggest that the market may be overbought.
What could the MACD be suggesting about the S&P 500 now?
Timing is everything
Using a year-to-date chart as of August 20, 2013, the MACD line and signal line are relatively close to the zero line and do not suggest overbought or oversold conditions (see the chart above). The signal line is still in positive territory, however, it is nowhere near an extreme positive reading, relative to both recent and longer-term highs. In fact, it is trending lower toward the zero line.
The MACD line did recently make a negative cross below the zero line—which is a bearish sell signal. A sell signal is given when the MACD line crosses below the zero line, and a buy signal is given when it crosses above the zero line.1
Signal line crossovers, as opposed to zero line crossovers, are typically the more frequent action traders look for when using the 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. The last crossover signal was when the MACD line crossed below the signal line in early August. This was a sell sign. The next possible signal line crossover would be a MACD line cross above the signal line, which would be a buy signal.
Seattle Trader’s Summit
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. “We saw a bearish divergence between the S&P 500 and the MACD indicator, with higher highs in the S&P and lower peaks in the MACD,” observes David Keller, CMT, president of the Market Technicians Association and managing director of technical research at Fidelity. “This actually occurred on both the weekly and daily charts, and suggests that the momentum behind the market’s uptrend could be slowing.”
Many traders wait for a “trigger,” or some sort of confirmation of the divergence. Keller notes that, “S&P's breaking down through recent swing lows, a lower high in price, and the MACD's breaking the zero level all could serve as valid sell triggers.”