The relationship between short- and longer-term moving averages has strong predictive power for share price returns
Short-term stock market data often feel like a whole lot of noise that just gets in the way of good investing decisions. But new research finds that short-term signals from one closely watched market indicator can be highly useful in picking stock winners and avoiding losers.
The indicator is the “moving average,” which charts a stock’s average price over a specific period of time. A one-year moving average chart, for example, is updated every day with the latest price while dropping the first price at the beginning of the one-year period. The idea is to smooth out day-to-day volatility and reveal a stock’s basic trend — up, down or flat.
A working paper by Doron Avramov of IDC Herzliya (Israel), Guy Kaplanski of Bar-Ilan University (Israel) and Avanidhar Subrahmanyam of UCLA Anderson shows that the difference between a stock’s 21-day moving average and its 200-day moving average is a reliable indicator of where the stock is headed in the near term. Overall, it’s bullish when the 21-day average price shoots above the 200-day average. And it’s bearish when the 21-day figure tumbles below the 200-day figure.
Some “momentum” investors have long considered the relationship between short-term and longer-term moving averages an important trend indicator. They even have a term for the point at which a short-term average line (such as the 21-day) rises above a longer-term line (such as the 200-day): the “golden cross.” (And, ominously enough, the chart pattern traced when the 21-day average falls below the 200-day is known as the “death cross.”)