Thursday, February 16, 2012

The Red Line

2007-2009 Bear Market
Today I am going to teach you about the importance of the 200 Day Moving Average. This particular moving average has several functions that are often overlooked by the amateur investor. One belief that many investors associate with is by using this moving average, one can determine a specific area of support or resistance. Other conventional wisdom suggests that by using  the 200 day MA in conjunction with the 50 Day MA, a bull or bear market can be defined. A "golden cross" is when the 50 Day MA crosses above the 200 Day, signaling the birth of a new uptrend. Conversely, A "Death Cross" is when the 50 Day MA crosses below the 200 Day MA, which supports the notion that prices are in a downtrend.

So what's so important that we all seem to not understand? It is the SLOPE of the 200 Day Moving average that has greater meaning. Let me explain.

As you can see in the chart above, I have used the previous Bear Market of 2007-2009 to illustrate my point. Notice the slope of the red line(200 day MA) begins to flatten out at the peak of 2007. Following this flattening out period, that same red line began a downward slope. Anytime that prices rallied back up to a downward sloping 200 day MA, resistance was met by sellers of the market. The point is, when that line rolls over to one that is declining, technical damage has been done in the marketplace. Here is another example.

Bear Market of 2000-2003
It might also be important to mention that evidence of a declining slope only suggests that the we are in the beginning phase of a Bear Market. Following this phase, the 200 day moving average will go from having a declining slope to one that has falling slope. At this point, prices become extremely stretched from their moving average, and decline at an unsustainable angle. In other words, prices go into free-fall mode.

Bear Market of 2007-2009
Once the red line begins to curl upward, the Bear Market is over. It is here that prices are extremely oversold and due for a reversal.

The Bear Market of 2011-
The declining slope of the 200 day moving average is very bearish. The July sell-off did enough technical damage to allow for a multi-month snapback rally.  We cannot compare this sell-off to the one in May of 2010 because the red line flattened out. A declining slope cannot automatically reverse and begin to rise. The sequence of events must fall in the order in which I explained them.

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