Is This Popular Indicator Bogus? Here's Why It Doesn't Matter...

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Lately, I've been noting the importance of the 200-day moving average ( MA ). The first chart I want to look at this week shows that the S&P 500 failed to break above that MA.

I've also highlighted another section of the chart that is a good illustration of how important the 200-day MA can be. During that period, the index reached its top in October and began selling off. The initial declined when the price broke below the 200-day MA.

For almost eight weeks, the S&P 500 remained within a few percentage points of this level. Then, in early December, the index broke sharply below its moving average, sparking a 15% tumble that reached a low of 2,351 on December 24.

In the six weeks since those lows, the S&P 500 staged a steady rally back toward its 200-day MA (spurring an increase of bullish opinions)... but it stalled out last week after failing to break through the MA for two days.

What's The Deal With The 200-Day MA?

Many investors hold strong opinions about the 200-day MA, and whether it is truly important.

Some investors argue that this so called "indicator" can't have any real significance because it is simply a line on a chart, and 200 days isn't even a meaningful timeframe. How can a chart level determined by some arbitrary number of days have any impact on whether a stock's price goes up or down?

In a way, those investors are correct. The 200-day MA is simply a line on a chart that uses a relatively random timeframe for its calculation. But here's the part they're missing...

The 200-day moving average is meaningful because we give it meaning . In other words, it's significant because so many investment professionals follow it.

Here's a fun game: Try picking a truly arbitrary number (for instance, 42 or 265) and set that as the period for the simple moving average. Now, look at how the S&P 500 moves with respect to the line. Odds are good that the index won't show any kind of meaningful relationship to that MA... because it's a truly arbitrary number that you picked out of a hat and applied to a chart . Millions of investors and institutions aren't tracking the 42-day MA or using it to inform their decision to buy or sell.

But you know what they are tracking? The 200-day moving average.

When the S&P 500 falls below its MA, many fund managers start increasing the amount of cash they're holding. Hedge fund managers often tilt their portfolios to the short side. Analysts on CNBC reference it throughout the day, offering a running commentary as the price action approaches the average or veers away.

In fact, it's the same reason that fundamental indicators like the price-to-earnings (P/E) ratio are significant. They're important because we have decided they're important, and, as a result, we're all watching the same levels and responding accordingly. In the stock market, a factor is important simply because it is in the news.

Once again, the rational individual will argue this is nonsensical. Something cannot be important just because other people think it is. But that is the way many things work. Politicians are important only if they get noticed in the media. Social media comments are important only because they have users. Actors are important only because they have fans.

I tell my Profit Amplifier readers all the time... Like politics, social media and the entertainment industry, the stock market is partly a popularity contest. That's why it's worthwhile to pay attention to popular concepts like the 200-day MA; even if you don't like the "logic" behind them, the majority of investors do, which means we should keep an eye on these indicators to see whether the crowd is likely to be buying stocks or selling them.

Sentiment Also Tells An Interesting Story...

As the recent rally entered its fifth week, the crowd started to become increasingly bullish. This is measured in the chart below, which shows the data collected from the American Association of Individual Investors (AAII) Sentiment Survey. Notice how the green line (bullish investors) started to tick back up around January 31. During the same period, you can see the red line (bearish investors) is also heading lower and has dropped significantly since the S&P 500 bottomed out on December 24.

​Every week, AAII gathers this sentiment data by asking members to answer one question:

Research has shown there is some value in following the data. Funnily enough, the most important sentiment indicator isn't whether more investors are bullish or bearish -- it's the percentage of neutral investors (navy line). Extremes in this indicator usually develop at important turning points.

For example, while the market was bottoming in December, the percentage of survey takers who expecting "no change" fell to its lowest level in months. At the time, a majority of the investors in the survey were bearish. These two pieces of data combined to indicate that a short-term bounce was likely.

Currently, a plurality of respondents is bullish, and the number of bears has fallen to its lowest level since early October. Maybe it's a coincidence, but this setup looks very similar to the setup pattern that emerged in early October -- right as the stock market peaked.

The Key Takeaway

​ However, it's probably not a coincidence. History has shown us that the majority of investors are often wrong at important turning points, which means we could be approaching a possible reversal in the stock market right now. The price action and sentiment are combining to point to a decline in the next few weeks.

Maybe it will be a consolidation that sets up a successful break of the 200-day MA on the next rally. But fundamentals remain negative, and the stock market must incorporate several important news events in the next few weeks. Traders must contend with the possibility of another government shutdown (February 15), the end of the pause in the trade war with China (March 1) and Brexit (March 29). The probability of good news from all three events is low, and that indicates a breakdown in the stock market is more likely than a sustained rally over the next six weeks.

It's almost certain that we'll see the S&P 500 test its 200-day MA again this week, and a rally above this level would likely change things. However, the weight of the evidence is still leaning toward a bear market thesis.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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