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The Importance of 200

200-day-mvg-avg-channel1

Something I follow but don’t write much about on the blog is the importance of watching the price of an index or a stock compared to the 200-day moving average and the 200-week moving average.

If you look at the chart above of the S&P 500 Index over the past 20 years, you can see how the 200-day moving average (the red line) acts as support for the market during an uptrend and as resistance during a downtrend.

[as always, you can double click all the charts for a better view]

What is less discussed on investment TV and other blogs is the usage of the 200-day moving average in helping to determine whether a market or a company is over-valued or under-valued.

To do this, I like to watch the price of the S&P 500 Index as it moves within a +10% to -10% band around the 200-day moving average. I’ve shortened the time frame in the chart below to 10-years so you can more readily see the price movements:

200-day-mvg-avg-channel-5-year

Whenever the S&P 500 Index moves to a level that is 10% above or below the 200-day moving average, the market sets up for a move in the opposite direction – unless you have a situation like the 2008 stock market crash where the market itself became so severely undervalued that moves greater than 10% beyond the average to the downside are offset in the correction back to more normalized valuations.

If you look at where we are today, you can see that the market itself is telling us that from a technical valuation standpoint it is time to pull back toward the 200-day moving average.

The question I get via email fairly often when I explain my reading of graphs here on the blog is why it matters. The answer is that the price movement as illustrated by the graphs as well as the various indicators I follow give me a feel for the psychology of the market. Investor psychology equates to how excited they are to pay more or less for the earnings of companies, which gives you expanding or contracting P/E multiples – and lets you know whether investors are paying too much or too little for earnings because they have gotten too excited or too negative. For me, the visual interaction of the price movement on the graph with its past helps me to spot situations where investors have gotten too excited or too negative, making the analysis of how aggressive or conservative to be much easier.

As I look at this chart, I see a market that is in a sustained uptrend off the March 2009 post-crash lows – it is one that gets a little too much excitement and pushes ahead of itself from time to time (as shown by the touching of the top band meaning it has moved 10% away from the 200-day moving average) and needs to have a healthy pullback, maybe even to the 200-day moving average, so that it can then make the next step forward. You can see that happened twice in 2012 and there is every reason to believe it will happen in 2013.

But, I like to double check what the chart is telling me, so I like to also look at where we are compared to the 200-week moving average, just to see if it is confirming what the 200-day moving average is saying.

200-week-mvg-avg-channel

The chart above gives you a 20-year view of the 200-week moving average of the S&P 500 Index. On this chart, what I like to watch is a +25% to -25% band around the 200-week moving average to give me a feel for whether the market psychology has gotten too optimistic or too pessimistic.

In looking at the chart, you can see that it is confirming what the 200-day moving average chart was saying – we are at the point where it will be healthy to have a move down in price for the market.

What we do not want to see is a change in the uptrend to a downtrend when we get the move down in prices. To give me a feel for that, below is the chart I’ve shared with you at various points in the past:

trend-change-indicator

I’ve circled points on the chart that tell me when a trend has changed – you can see that the top section of the graph moves above its upper indicator or below its lower indicator lines shortly before the trend in the market changes – as depicted by a move in the price line below the moving average. What I see here is that we have not had a change in the trend (we may still yet depending upon whether the market actually pulls back in price in a significant manner) because the price chart in the pink circle on the top right side does not show the price falling below the moving average line (10 month moving average in this case).

Ideally, what we would want to see is the market pull back to the 1450 to 1460 range on the S&P 500 – that would set the market up for a strong move higher in its next leg – it would shake out the new entrants that do not have a long-term investment horizon and it would help prevent an even larger move lower to the -10% band on the 200-day moving average (like we experienced in 2011).

Will we get the move to 1450? Its possible, but we’d need to get the fear level up much higher than we currently see it. Right now, unless the fear level increases, we will most likely experience a 3% to 5% correction off the highs (3% correction takes us to 1,545 and a 5% correction takes us to 1,513). To measure fear, I watch a number of charts that you can find in my post on Risk Management but just to tell you where we are on the VIX we have seen a 50% upward move on that indicator, but it is still well below levels that say there is rampant fear among investors.

So what should you take out of this post?
>The market got a bit ahead of itself by moving to 10% above the 200-day moving average;
>that investors can get too excited and act irrational, paying too much for equity investments;
>that it is healthy for an up-trending stock market to pull back toward the 200-day moving average as that sets it up for another leg higher based upon better/more realistic valuations;
>that there is not enough fear in the market yet to show we will get a move all the way back to the 200-day or 10-month moving average at 1450 to1460 on the S&P 500 index, but fear has increased to make at least a move to 1545 or 1513 quite possible; and
>that we are seeing no change in the overall uptrend at this time but that we are watching it closely to make sure.

Pull backs are natural, part of the process of investing, and ultimately profitable for investors who have cash on-hand because they can buy shares of companies at better valuations than others paid in the recent past. This is the situation we are currently in, having ample cash on hand, and it is one I feel good about as my eye in on beating the market over the long-term not just sporadically in the near-term.

My last piece of advice: invest what you see, not what you believe. Believing what you hear on investment TV and wanting to be fully invested when you see the market saying that it needs to correct is just not the best plan. Raising cash, letting it correct, then putting that cash to work is always the best, most profitable plan for the long-term, one where you have less chance of getting hurt than chasing prices at the top of the market.


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