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  • The 200-DMA can signal important inflection points.
  • The 50-DMA and 21-DMA offer useful insight to shorter-term investors.
  • Be careful not to force a moving average period onto a chart to justify your opinion.

Over the weekend, I highlighted research showing how the buy-and-hold approach to owning the S&P 500 outperformed a market timing strategy that only held the index when it was trading above, rather than below, its 200-day moving average.

The outperformance associated with the buy-and-hold approach was significant, so you might be wondering if you ought to pay moving averages any attention. The answer is yes. Why? Because moving averages can be a handy tool for gauging investor optimism and pessimism, making them a pivotal input to determining if the market is healthy or not and, thus, how aggressively you should be investing.

Moving averages can be profit friendly

The 200-day is the most commonly referenced moving average because it approximates one year of trading activity. By tracking where price sits today relative to the past 200 days and, importantly, whether the 200-DMA is rising or falling, we can quickly see if investors are optimistic or pessimistic, allowing us to decide if the odds favor buying pullbacks or shorting rallies.

The following chart of the S&P 500 ETF  (SPY)  illustrates my point. Notice how the 200-day moving average (black line) acts as a magnet. In 2018, after stocks broke down in the fourth quarter, they stalled at the 200-day moving average multiple times before rolling to new lows. Then, notice how once the S&P 500 recaptured the 200-DMA, it acted as support, stopping declines throughout 2019. It similarly acted as support in the post-COVID rally, and in 2022, as resistance, given the S&P 500 stalled at it multiple times. 

Is this a coincidence? I don’t think so.

CHART-Moving-Averages-101822

Regardless of investing style, most portfolio managers know where the price sits relative to the 200-DMA moving average. Perhaps, the 200-DMA is important because... it’s important – a self-fulfilling prophecy. It’s become so mainstream that algorithmic trading software is likely programmed to buy or sell based on it, making it more relevant than ever.

Consider this excerpt from famed investor Paul Tudor Jones from Tony Robbins' book, Money. He says:

“My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.”

The 200-DMA isn’t the only moving average investors track, though. Shorter- and intermediate-term investors often look to the 50-day moving average and 21-DMA for insight. We can see why when we zoom in on this year’s action. Specifically, notice how the 50-DMA (red line) and 21-DMA (green line) coincide with important tops and bottoms.

CHART-Moving-Averages-2-101822

When moving averages don’t matter?

Of course, you can create a moving average over any investment period. However, that’s not necessarily a good thing. There needs to be a rational explanation for why a specific moving average matters, such as the 200-DMA approximating a year.

In “Does the 200-Week Moving Average Line Make Any Sense?Real Money technical expert Bruce Kamich shares a story to illustrate his thoughts on the subject:

“In 1977, I was working as a futures broker and called on the purchasing department of Unilever (UL). The company purchased large quantities of soybean oil for margarine and salad dressing. They had a large chart of soybean oil on their office wall with a four-month moving average line [emphasis mine]...

I was new to the business and asked why a four-month moving average when futures traders used things like the 4-9-18-day moving averages or the 10- and 20-day averages.

Their answer was simple and meaningful -- four months was the shelf life of margarine.”

Kamich’s takeaway from that experience is that it's important to have a rationale for selecting a moving average. Otherwise, you run the very real risk of picking one that simply fits your narrative.

He writes:

“My lesson from this: moving averages should make some fundamental sense. A 12-month moving average on housing starts or some other monthly economic data. A 65-day moving average line because it is a quarter. Or a 15-month moving average line on cattle prices…

On CNBC this Monday morning, a noted strategist from Morgan Stanley (MS) talked about the S&P 500 and the 200-week moving average line. I am totally perplexed on how this time frame relates to anything. Sorry…Over the years, I have seen critics of technical analysis rail on about the use of trendlines, saying they are subjective and, if you "draw enough trendlines, are going to be right at some point in time."...A similar complaint can be leveled at the use of moving averages in that some time frame will give you the answer you seek. Let's not torture the data to give us the answers we want…For me, I am reminded of an old middle-eastern saying:

"If you truly seek wisdom, you will visit all the tents in the marketplace."

Kamich’s point reminded me of this quote:

“Facts are stubborn things, but statistics are pliable.” Mark Twain.

The Smart Play

I incorporate the 200-DMA, 50-DMA, and 21-DMA into my thinking. If the 200-DMA is rising and we’re trading above it, I’ll buy stocks more aggressively when markets pull back. I invest more defensively if it’s falling and we’re trading below it. In this manner, it acts as an input and a conviction tool for me.

I’m reminded of two more quotes:

  • “Nothing good happens below the 200-Day moving average,” source unknown.
  • “No stock in an uptrend has ever gone bankrupt," by long-time technician Walter Deemer.

Using moving averages can help you avoid the risk of owning stocks where the story changes, but you don’t want to believe it. Their use is akin to having a second set of eyes stress-testing your thesis. If a stock is below the key moving averages, sellers are dwarfing buyers. In bear markets, that can be because of indiscriminate selling as investors move to cash. Nevertheless, moving averages force you to revisit your thesis to ensure it isn’t busted. In this way, they can increase your conviction (i.e. the thesis is intact, so this could be a buying opportunity).

Moving averages can also inform when to take profits or exit a low-conviction stock because stocks don’t rise or fall in a straight line. When stocks get overly extended above the 200-DMA (70%-100% or more), it could be a good time to put some profit in your pocket. Similarly, it could be a good exit point when low-conviction ideas rally to their downtrending moving average.

You can use them to aid in where to set stop losses to protect yourself from losses, too. 

Just remember moving averages aren’t infallible. Stocks often over or undershoot them, and eventually, they’ll flip from support to resistance or from resistance to support. Since there are no free lunches, I run a band 5% above and below the 200-DMA to boost my confidence that a trend shift has legs. 

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