Chart of the Week: The S&P 500’s exponential moving averages flag a shift in the market

Technical analysis can easily seem to be an uneasy mixture of obscure jargon and seat-of-the pants guesswork, sort of the zany astrology counterpart to the hard-edged astronomy of Graham and Dodd. But fundamental analysis is far from pure science itself and new thinking in behavioral finance edges the mainstream ever closer to the technicians. Moreover, there’s a good case to be made that many quantitative models share the same underlying assumptions about the persistence of momentum and other trends that play out within some equilibrium. Our own process is driven by the search for discontinuous change and we are intellectual magpies about the market in general, including the findings of the technical analysts, albeit always with a healthy dose of skepticism.

One widely-watched measure of market momentum recently crossed an important threshold to give its first “buy” signal in six years. The idea behind a chart like this is that when a relatively short-term moving average of the market crosses above (or drops below) a longer-term moving average, then the market is signaling a shift in momentum into a new bull (or bear) market. In this chart, the moving averages are for 50 and 200 days and the exponential moving average gives more weight to recent data points than a simple moving average.

Over the past decade or so, the signals have been remarkably reliable, flagging a market peak in late 2001, a bottom in early 2003, and the next peak in early 2008. On August 11, the momentum indicators crossed again to flag a new bull market, a signal that has held up despite the sell-off over the past few days. Of course, history is stuffed with models that work until they don’t. This model itself was far less reliable prior to 2000. Even so, for students of change, the market could be confirming a sea change in the macro outlook.



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