Saturday, 20 March, 2010

200-Day Moving Average


In today's article I will discuss another key item that I use to gain a comprehensive picture of the state of the overall market--the percentage of stocks now trading above their own 200-day moving average. (To avoid repeating this long phrase, I'll just refer to this indicator as "% above 200.")

The concept here is simple. The 200-day moving average is perceived to be the dividing line between a stock that is technically healthy and one that is not. (To review how to calculate a moving average, please visit this link.) Some traders use the simple moving average for this measure. Meanwhile, others employ exponential moving averages, which give more weight to recent data. A stock that is trading above its 200-day moving average is said to be in an uptrend and is being accumulated; one below it is in a downtrend and is being distributed.

On the surface, it seems as though the higher the "% above 200" goes, the more bullish the market is (and the lower it goes, the more bearish). In practice, however, the reverse is true. Extremely high readings are a warning the market may soon reverse to the downside. High readings reveal that traders are far too optimistic. When this occurs, fresh new buyers are often few and far between. Meanwhile, very low readings signify the reverse; the bears are in the ascendancy and a bottom is near.

So, now that we understand the significance of very high or low readings on this indicator, we need to determine exactly what levels represent high and low readings. To interpret this indicator, four parameters are key: 20 and 40 on the low side and 70 and 90 on the high side. Throughout the last 20 years, readings around 20 have consistently marked key reversal areas. As the chart below shows, the 20 level marked Wall Street's bottom in October 2001, late July 2002 and October 2002. (I've circled each of these reversal areas below). With this in mind, when the % above 200 nears the 20% level, swing traders should be on the alert for a sharp, V-shaped reversal.

When the percentage of stocks above their 200-day moving average hits 20%, the subsequent rally is often capped at the 40% level. This level provided resistance in August 2002 and January 2003 and correlated with bear market rally peaks. When the official bull market began in March 2003, the number of stocks above the 200-day moving average decisively broke out above the 40 level. From there, it trended higher for the remainder of the bull market, ultimately reaching a peak just above 90.

On the flip side, swing traders should be very cautious when the number of stocks above their 200-day moving average goes above 85%. Historically, readings in this area have precipitated either a major correction or a bear market. The reading above 90%, which lasted through February and the early part of March 2004, was the most extreme reading I could find going back seventeen years to 1987! When it reversed in early April of 2004, it led to the official bear market signal.

When a reading peaks above 85%, 70% becomes an important support level. A break of 70% after the percentage figure has hit the high-80s or low-90s is a warning that, at the very least, an important correction is unfolding.

Swing traders can also examine the % above 200 using trendline analysis. The most effective way to do this is to draw trendlines on both the underlying NYSE (New York Stock Exchange) chart and the % above 200 chart. A break in the % above 200 trendline will provide you with confirmation of the message given off by the underlying price chart.

What is the indicator currently saying? Recently, we've seen a massive deterioration in the stocks trading above their own 200-day moving average. In early April 2004, the % above 200 indicator broke its up trendline. At that time, the number of stocks above their own 200-day moving average sat at historically high levels just below 90%. However, it has since fallen to 44%! That is an extremely rapid drop. So far the decline in price as measured by the NYSE has been relatively limited. It seems likely that price will need to catch up with the % above 200 indicator.

At 44%, the decline in the % above 200 indicator does not appear complete. Remember, it normally takes a reading near 20% before the market is oversold enough to turn around. That kind of bottom seems at least a couple of months away. Historically, the 40% level has seldom provided a platform from which the market has managed to mount a reversal.

In judging which way the overall market will move next, swing traders have a variety of tools at their disposal. Among them are price charts and indicators such as RSI and stochastics, both of which are based on price. In addition, over the past several months I've introduced you to a host of other measures that you can use to interpret the overall market. In the next installment of this "Inside The Black Box" series I'll connect the dots and will weave together these overall market indicators into a cohesive picture.

Good trading!

Dr. Melvin Pasternak
The StreetAuthority Swing Trader