Moving Averages Don’t Move Stocks

After a big surge to close Tuesday at 1941.28, the S&P 500 Price Index easily surpassed an average of its closing prices over the last 200 trading days, 1908.^[i] To many, that's trivia. But to bullish technical analysts, it's confirmation-time to breathe a sigh of relief-the market's bounce back is real! The 200-day moving average is a widely watched gauge for chart-lovers, and since the S&P fell through it recently, it has been a source of great consternation for some. But in our view, using stocks' 200- (or any period, really) day moving average to predict future direction is pure folly. Past performance-whether smoothed, averaged or other-does not dictate the future, as the S&P's recent ride (again) shows.

For the unfamiliar, the 200-day moving average is a very common technical indicator. Broadly speaking, proponents argue if the S&P 500 is above its 200-day moving average, it should continue rising. If it falls through this average, look out below. Many cite instances when the 200-day moving average was broken during bear markets and, sometimes, corrections. But that is just kind of a function of longer-term average meeting shorter-term sharp move. It isn't predictive, just a result.

Overall, the rule that breaking the 200-day moving average predicts bad times ahead doesn't pass the logic test. If the S&P 500 staying above its 200-day moving average indicates future gains, stocks should never fall. Likewise, the S&P falling below its 200-day moving average would mean stocks would never rise. Both statements are quite obviously faulty, but when the S&P fell towards-and ultimately breached-its 200-day moving average last week, many technical analysts saw stocks entering a longer-term downtrend. However, unless you define "longer-term downtrend" as seven trading sessions, we'd say those concerns were a teensy bit off. (Exhibit 1)

Exhibit 1: S&P 500 and 200-Day Moving Average in October

Source: FactSet, as of 10/21/2014. S&P 500 Price Index and 200-day moving average, 10/1/2014 - 10/21/2014.

Now, we are not arguing the recent bout of volatility is over. Maybe this is what the industry calls a "dead-cat bounce" and the S&P will fall below its 200-day moving average again tomorrow ... Or next week ... Or next month. It's possible! Sentiment-driven moves like corrections and smaller dips are totally unpredictable. In our view, more important is identifying the longer-term trend-is a bear market forming? (A fundamentally driven decline exceeding -20% for a considerable period of time.)

However, there is no sign the 200-day moving average reliably predicts corrections or bear markets. The current bull has been below its 200-day moving average before-and for longer than seven trading days, too. Yet that hasn't stopped the S&P 500 from rising 187% overall^[ii]. (Exhibit 2)

Exhibit 2: S&P 500 and Its 200-Day Moving Average From 3/9/2009 - 10/21/2014

Source: FactSet, as of 10/21/2014.

This isn't an isolated phenomenon. The decade-long 1990s bull wasn't derailed when it fell below its 200-day moving average either. (Exhibit 3)

Exhibit 3: S&P 500 and Its 200-Day Moving Average During 1990s Bull Market

Source: FactSet, as of 10/21/2014.

If you look closely, you might notice stocks frequently cross the average after a significant amount, if not most, of the downside is over. That's the opposite of predictive, a less than ideal tool to guide your strategy.

Recent market volatility also exposes the shortcomings of the 200-day moving average's value. Though early October's negative volatility dominated headlines, we've seen a lot of positive volatility lately-the S&P 500 popped higher in recent sessions.^[iii] By no means are we suggesting stocks will keep rising just because they've been up and crossed back over that 200-day line. Momentum doesn't apply in markets, as today's price action has no bearing on tomorrow's. So using a lagging average of past performance to predict future jumps and drops seems like just another attempt to conjure an easy predictive rule-despite the fact complex, adaptive systems like stock markets will quickly negate virtually any such tool, to the extent it worked in the first place.

Instead of consulting the charts, there are real reasons for bullishness despite recent volatility. Many underestimate the strength of the global economy-a nice backdrop for the bull to run on-and fear instead possible global deflation or the weak eurozone's impact, both indications false fears still linger. Political gridlock lowers the likelihood competitive developed countries enact legislation that could impact radical changes, like revising property rights-reducing uncertainty for markets. And while sentiment has been improving, it remains far from euphoric-many headlines questioned the bull's strength after the recent market pullback, a sign investors are more bullish, but not dismissively or complacently so. For these fundamental reasons, we believe this bull market still has plenty of room to run.