Plenty of people pay attention to a technical signal called the 50/200 moving average crossover. While this indicator can be somewhat useful sometimes, this isn’t one of them.
While the prospects of the Dow’s 50 day moving average crossing over its 200 day moving average is making the news these days, this particular instance at least isn’t much to get excited about.
This signal is the favorite of many amateurs and even some professionals use it, even though it’s not a particularly good one due to the lag involved.
All technical indicators lag somewhat, and the trick is to use that lag to smooth out the noise on a chart and provide a reliable signal. Ideally, you want this signal to be indicative of the present market trend and not be too isolated, and the 50/200 is an example of one that is quite isolated and requires long trends in order to be reliable enough.
We do get these trends enough though that you can trade this signal and beat the market with it, especially if you play both the long and short sides of the signal. Anything that is right even a little more than it is wrong will do that though. Just because something may work generally though doesn’t mean that you want to use it generally, and during times where the trends are shorter, this will not only have you out of touch but going against clear trends.
If we look at where the 50 last crossed downward over the 200, we can see an excellent example of this. This signal had us long throughout the late 2018 decline, finally giving way and shifting us to a long position at the bottom of the move. We would still be short here, throughout the entire rally of the last 10 weeks or so.
The fact that this might be crossing back up may not be that reliable at all then. The worst-case scenario with this signal is to have us see a move against us sufficient for it to cross over, and then head right back in the other direction with our being on the wrong side again, and this very well may be the case this time, if the Dow even gets up that much to even cross.
The Dow’s upward momentum of late is certainly indicative of it showing real signs of tiring, and this week, we’ve now gone from trading pretty flat to what looks like a reversal in the other direction, with the last 5 sessions of the Dow all closing lower.
Technical Signals Really Benefit from Further Confirmation
A signal like the 50/200, along with other combinations of simple moving averages, are sometimes referenced in introductory books on timing markets for investors, and the reader is shown that certain combinations have beaten the market over a certain amount of time, but this does not mean that we should be actually trading these stand-alone indicators.
In order to improve our results, we do need this signal confirmed by something else, even if it’s just a look at the price movement itself. Price movement should always be a consideration when using technical indicators because price on a chart, the current trend in other words, does not suffer from a lag, and while we can use the lags that indicators provide, we don’t want the lag to take us too far out of touch with what is actually happening lately.
This applies to both timing our entries and exits, and if we get in a bad spot like using the 50/200 signal that we saw in late December, when we’ve had a big run like we did at the time, we have to be ready to jump off if the trend shows real signs of reversing, in spite of this signal having us staying in.
Traders have a bevy of tools at their disposal to find the good signals and weed out the bad, and there are some signals that are well superior to the 50/200 that would have had us long throughout this bull run and have us getting off the bus a few days ago. We do need sufficient action to show that a trend is over, but those that are aimed at the trend much more closely than the 50/200 cross does provide better results overall.
A simple example would be the slope of the 10 day moving average on a Heikin Ashi chart, bars similar to candlesticks but ones that in themselves perform averaging. The short exit and long entry occurred on Jan 4, fairly early in the move, and had us riding this right up to 3 days ago, when it reversed again.
Seeking the Right Balance Between the Past and the Present
The goal here isn’t to try to pick tops and bottoms too tightly, as this will generate too many false signals, but to do so tightly enough that a reliable signal will be obtained with a minimum amount of movement against us required to generate it. 50/200 crosses don’t even come close to doing this and require much more significant moves to signal a reversal.
The reason why the 50/200 and similar moving average crosses are sold to investors is that they simply do not trade on timeframes that tighter signals use, like our 10 day moving average slope change. This does not mean that they need to settle for moving average crossovers. We’ll of course have to give these signals a lot more room than if we were looking to trade over a period of just a few days, weeks, or even over a few months, but we can still do better to get closer to the action than moving average crossovers allow for.
When we speak of things like the 2018 Q4 swoop, or the recovery underway since, we aren’t using investing time frames at all, and it is important that investors who are looking to trade much less frequently understand this. If we told investors that we’re moving to the downside last October, for instance, this does not mean that they need to do anything, because if they did, they would be committing themselves to the same reasoning when it turned back up at the start of this year, and this would have them trading, not investing.
The shorter-term outlook is clearly downward now based upon any reasonable measure, but we need to ask ourselves whether this is something we need to take heed of. Any investor who rode out the 2018 Q4 bear run, where we gave back 20%, isn’t going to be put off at all by a few percentage points given back that still has us well ahead of where we were at the bottom of this latest hill.
On the other hand, most investors could really benefit from tightening up their signals, or in almost all cases, even having one. Even using tighter signals that encompass a timeframe long enough for investors has us still moving forward though, through the last bear run and likely through anything this current move down is likely to throw at us anytime soon.
Watching the market vacillate between up and down trends and looking at where we might be headed in the short term may be interesting enough, but this is all well outside the scope of the longer-term perspective of investors.
With that said, if we do see a 50/200 cross soon, this really doesn’t mean that much to those whose stock in trade are these shorter time frames either, and we’ve actually seeing the cap being put on further advances, particularly with the way this week has panned out.
This information can serve to prepare the investor to be more on guard for the potential for reversals that they indeed ought to be paying attention to, but by the time these longer-term signals occur, there’s no real doubt that we are in a bear market. This is far from the case right now though.