Technical analysis boasts numerous investigative methods and tools to diagnose the market trend but none are simpler or more extensively used than moving averages. Maybe because they are so basic and widely accessible, moving averages are often dismissed as useless by professionals. We on the other hand find them quite useful and there is just no substitute for their unmatched ability to graphically depict what is going on in the market. Don't get us wrong, while simple strategies such as crossing moving averages can provide returns better than the market, we do not believe that moving averages by themselves provide a sufficiently consistent and timely trend indicator. Moving averages account for about 10% of our Model which is dominated by price and volume actions and relationships. However, as one of a number of combining indicators, they are extremely valuable and worthy of a short introduction.

Moving averages essentially consist of a series of averages over a number of time periods. There are two different types of moving averages.

Simple Moving Average (SMA)
As the name indicates, an SMA is the simple arithmetic average calculated by adding the variable (the closing price of an index for example) for a number of time periods and then dividing the total by the number of time periods. Generally in investing the time periods are days. Probably the oldest market timing strategy in the book is to buy when the market (or index) is above its fifty day average and sell when it crosses below. As usual the devil is in the details. How tight you define the words "crosses below" and how rapidly you react can mean the difference between being whipsawed constantly for no gain if you take any crossing as a signal, and missing big opportunities if you wait until it crosses by five or ten percent.

Exponential Moving Average (EMA)
Unlike the "equally weighted" SMA, the EMA gives more importance to recent time periods. The way the EMA is calculated has a smoothing effect on the graph (see Chart 1) and eliminates the lag which is inherent to the SMA. The current market conditions illustrate the point perfectly, as you can see that the blue EMA (200) line turns up on the day it is crossed to the upside by the Nasdaq Composite Index, while the orange SMA (200) lags behind and is still pointed downward today, almost two months later. Because of its smoother, faster behavior, the EMA is the average we like to use mostly.

The number of days used to calculate the moving average modifies its role and character, but the average always retains its ability to reveal a trend. You could use any arbitrary duration but because specific ones have become "de-facto industry standards" and are widely published and tracked, they tend to be the ones that work. Many argue that a few of these moving averages are so popular and widely followed that they are in fact acting as self-fulfilling psychological barriers. Regardless of the reasons, the major moving averages play an oft demonstrated resistance and support role, especially the longer duration ones. Looking at Chart 2 it is uncanny how frequently the Nasdaq Composite bounces off its moving averages, providing the observing investor great market reversal detectors. The most widely used durations are the ones shown in the chart: the ten-day EMA which provides a short term, two-week snapshot, the workhorse fifty-day average as a good mid-term indicator, and the two-hundred-day (almost a year) EMA for the long term horizon.

The market undoubtedly looks most healthy when the the Nasdaq Composite Index is above its EMA (10), which is itself above EMA (50), itself above EMA (200). Crossings are good trend change indicators. The strongest indicators are when all three EMA lines have been crossed as, thankfully, has been the case lately.

During trending markets as we had during most of 2003, the EMA 10 and EMA 50 crossover provides a solid indicator. During choppy and range bound phases, the pair is less effective. Another Trend Timer favorite is the use of 10 and 200-day EMA crossovers as long-term bull and bear market indicators as described in the October 31, 2003 Trend Timing School editorial.

Those interested in more details, formulas and strategies about moving averages can visit sites such as StockCharts.com at: http://www.stockcharts.com/education/IndicatorAnalysis/indic_movingAvg.html

In the "Trades and Cumulative Returns" table on the "Results" page and in the "Returns since" table on the "Current Signal" page, the third column labeled "% Return (No Margin)" frequently has readers puzzled. "How can it be that, at times, the numbers in the column are positive when the market lost ground or vice-versa?" is a common question we receive.

Since the column is intended to track the performance of our signal with the Long and Short strategy, this is perfectly normal and the numbers are correct. During Sell signals, being short the market, we gain when the market drops and lose when it rises.  

Warm wishes and until next week.

The TimingCube Staff