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What breaking the 200-day moving average for stocks really means
By Mark Hulbert

* October 14, 2014

It usually means bad news, but that’s not the case today

CHAPEL HILL, N.C. (MarketWatch) — The breaking of the 200-day moving average means the stock market’s major trend has officially turned down.

Or does it?

It’s urgent that we find out, since the Dow Jones Industrial Average DJIA, -0.04% closed last week below this crucial technical level, and the S&P 500 SPX, +0.16% did so yesterday.

In fact, some technical analysts consider breaking below the 200-day moving average to be the official end of a bull market. So, at least according to this definition, we’re now in a bear market. (The usual definition is a 20% or more decline.)

The situation may not be that dire, however. While market-timing systems based on the 200-day moving average had impressive records in the earlier part of the last century, they have become markedly less successful in recent decades — to the point that some are openly speculating that they no longer work.

In fact, since 1990 the stock market has actually performed better than average following “sell” signals from the 200-day moving average.



This is well illustrated in the accompanying table. “Sell” signals were those days on which the S&P 500 dropped below its 200-day moving average after the previous day being above it; there have been 85 such occurrences since the beginning of 1990. The returns in the table reflect the dividend-adjusted return of the entire stock market (as judged by indexes such as the Wilshire 5000 W5000, +0.28% ).

                                            Next four weeks	Next 13 weeks	Next 26 weeks	Next 12 months 
 Following ‘sell’ signals from 200-day moving average	2.5%	5.4%	        6.1%	        9.7% 
 All other days	                                        0.9%	2.7%            5.6%	       11.7%

To be sure, notice from the table that at the 12-month horizon, the stock market performed slightly below average following “sell” signals from the 200-day moving average. But, given the variability in the data, this difference in returns turns out not to be significant at the 95% confidence level that statisticians often rely on to conclude that a pattern is genuine.

By the way, the difference in 26-week (six-month) returns also is not significant. But the four- and 13-week results are quite significant.

Just consider the last time the S&P 500 dropped below its 200-day moving average — which was in November 2012, just after that month’s presidential election. The stock market almost immediately resumed its powerful rally, and the Wilshire 5000 was more than 3% higher in a month’s time, 12% higher over the next quarter, and 32% higher over the subsequent year.

An almost identical outcome was the result of the previous time the S&P 500 slipped below its 200-day moving average, in June 2012.

Of course, the market hasn’t always performed so impressively in the wake of a “sell” signal from the 200-day moving average, but in recent decades this has been more the rule rather than the exception.

To be sure, the pre-1990 results paint a different story. So, in order to determine your response to the market’s current violation of the 200-day moving average, you must decide whether the last couple of decades are just an aberration — or, instead, whether something more or less permanently has changed that renders the moving average less effective.

One important straw in the wind in this regard is research conducted by Blake LeBaron, a Brandeis University finance professor. He found that moving averages of various lengths stopped working in the early 1990s not only in the stock market, but also in the foreign-exchange markets.

Since those two markets are not linked in any obvious way, that would otherwise explain why moving averages would fail simultaneously in both. LeBaron’s research provides support for those who believe that the moving average’s fading effectiveness is more than just a fluke.

What might have caused that to happen? LeBaron speculates that it could be the confluence of several factors. One big one, he told me, could be the advent of cheap online trading, especially the creation of exchange traded funds — all of which made it far easier to trade in and out of securities according to the moving average.

Another factor, he said, could be the moving average’s popularity. As more investors begin to follow a system its potential to beat the market begins to evaporate.

In any case, it’s worth stressing that the results presented here don’t necessarily mean we’re not in a bear market. What they do mean: If we’re now in a bear market, it will be for other reasons besides the violation of the 200-day moving average.

http://www.marketwatch.com/story/what-breaking-the-200-day-moving-average-for-stocks-really-means-2014-10-14?link=MW_popular

George.

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