As I often discuss in my weekly newsletter EPIC Insights, I prefer simple technical patterns
such as trendlines and moving averages over elaborate systems. By examining clear price points, I
can dedicate more time to forecasting than interpretation.
When using moving averages (MA) to forecast the future, we often look for ways in which
time series relate to one another. A popular technique is the double crossover method, which
involves watching two different MAs. When the shorter time period crosses over the longer time
period, it indicates a reversal is occurring and investors should alter their approach.
For example, consider the current status of the Dow Jones Industrial Average (Dow). When
the Dow reached an interim peak of 8,574 on May 8, the 50-day MA was nearly 1,600 points below
the 200-day MA. With the shorter time period below the longer, it indicated that the trend remained
bearish. By June 30 the Dow declined to 8,447, but the 200-day MA is only 39 points above the 50-
day MA. As the stock market has enjoyed its best quarter in nearly a decade, the 50-day will move
above the 200-day MA in a matter of days.
Were we to follow simple rules, this reversal would indicate the markets are preparing to
resume an upward move, signaling us to buy.
Unfortunately, following set rules often leads to disappointment. To understand the ability of a
double crossover to predict market direction, I examined the Dow from January 1, 2000, until June 30,
2009. During that period, someone who invested in the Dow with a buyâ€andâ€hold mentality would have
suffered a loss of 26%. Conversely, an investor who bought the Dow when the 50â€day MA crossed above the 200â€day MA and shorted the Dow when the 200â€day MA fell below the 50â€day MA would have
Does this mean we should rush to buy stocks at the pending cross? Not so fast.
A more detailed look at this time period shows that an investor who followed the mechanical
trading program would have done 13 trades. Of these only four were profitable. As the Dow attempted
to determine future moves, a mechanical trading program would have had a maximum drawdown of
nearly 40% at the same moment at which the Dow buyâ€andâ€hold approach faced a loss of 10%. In fact, only by capturing the bulk of the bear market decline was the trading approach able to generate positive
From all this data I draw a simple conclusion. The double crossover may have an impressive
track record, but that record is built on the ability to capture wide moves. As the crossover occurs, we must assess whether this is a moment in which the broad market will immediately move higher, or if it
indicates a sideways movement with little progress. Forced to choose, I pick the latter.
With a market that has consolidated since early May, we now enter an uncertain time. The
strong rally from the March lows was driven in part by an oversold market, but hope of the recession
ending was a significant factor as well. Secondâ€quarter earnings are around the corner and the market
will quickly determine whether the rally is valid. I continue believing the foundation of this move higher
is shaky and that any indication of fear will send investors to the exit door. Those expecting the 50â€day
MA to signal that all is right with the market should consider these factors prior to plunging into stocks.