Some long-time readers of Real Money may know that I taught technical analysis at Baruch College in New York City for 21 years. Through the years, I introduced some 4,000 students, over the fall, spring and summer semesters, to the subject, from the history and logic behind it to charting methods and, of course, many indicators.
One of the easiest indicators for young minds to grasp and apply are moving averages. The math is relatively simple and the signals are black and white. I often had a guest lecturer who extensively used moving averages visit the campus and cover the subject from A to Z. The topics included:
What price to average?
What length of time to use?
The four types of averages.
The 1, 2 and 3 moving average systems.
Granville's rules for the 200-day moving average.
The most important message that my guest, the late Larry Laterza, would emphasize was that you need to trade in the direction of the moving average -- if the slope was positive you should go long.
I find it bothersome that so many commentators on the financial cable channels talk about the crossing of the 200-day line as being bullish. In fact, 70% of some 36 global stock markets are now above their 200-day moving average lines. If this was an important signal then I would tend to believe that a huge influx of money would be pouring into the global stock markets right now.
Now let's look at a couple of charts.
In the chart of the Dow Jones Industrial Average (DJIA), below, we show a close-only line chart and the 200-day simple moving average line. Notice in late 2013 that the DJIA closed above the 200-day line BUT the slope of the line was still negative. The rally did not hold and the decline resumed.
Look closely at April 2022 now. The DJIA closed above the 200-day moving average line BUT the slope of the line was negative. And now, again, the DJIA has closed above the 200-day line but the slope is still negative.
In case you think the DJIA is too narrow of an index with only 30 stocks we can see the same results if we look at this chart of the S&P 500 (SPX), below.
Or maybe you are wondering how the price of Gold performs when it closes above the 200-day moving average line? It does much better when the slope of the line is positive.
Bottom line strategy: Moving averages are a great technical tool that can be back-tested to see how they work. Their signals are black and white. They can be adapted to any time frame that you want to operate in and they smooth out the trends. But like all indicators they have drawbacks.
All moving averages are late by definition. Short-term moving averages can generate too many signals and too many false signals. Long-term moving averages produce less signals but they have a bigger "give back" when the trend reverses and are slower in generating a buy signal.
(More information about moving averages and other indicators can be found in my book "How Technical Analysis Works"
