by: Richard A. Anderson
On Monday of last week, the Dow Jones Industrial Average snapped a 501-day trading streak by falling below its 200-day moving average. According to Bespoke Investment Group, the 501 consecutive day streak above the 200-day moving average is the Dow’s third longest since 1952.
Prior to Monday, the last time the Dow closed below its 200-day moving average was June 27, 2016. The driver of that movement was the United Kingdom vote to exit from the European Union. This time, markets were driven lower by heightened fears of a global trade war following new tit-for-tat trade tariffs between the United States and China.
Why is the Dow closing below its 200-day moving average important? Traders use the 200-day moving average to gauge the long-term momentum of a security or index. When the price is above the 200-day moving average, that is a positive sign, often referred to as a bullish signal. When the price dips below the 200-day moving average, that is a negative sign, often referred to as a bearish signal.
While the financial media has jumped all over this story and come to the conclusion that now is the time to sell because of this bearish signal, it’s important to keep this signal in perspective.
Markets tend to be more volatile when they are below, rather than above, their 200-day moving average. The ride tends to be smoother when there is a defined uptrend rather than a downtrend.
However, just because the Dow closed below its 200-day moving average does not necessarily mean we are headed for a significant market decline. The slope of the average, referred to as the prevailing trend by technical analysts, is a more important signal than the moving average. Currently, the 200-day moving average slope is ascending, which is still consistent with a market in an upward trend.
The price can move below then above over and over again, and it won’t necessarily be a bullish or bearish signal. The 200-day moving average is a single variable that should be gauged in the context of other variables. Following just one variable leads to false signals, which can cause followers to incur higher trading costs, increased taxes, and may not ultimately provide for higher returns.
Looking back at the last time the Dow closed below its 200-day moving average on June 27, 2016, the markets didn’t sell off. In fact, the Dow closed above its 200-day moving average just a few days later and continued its uptrend. Those market participants who followed the 200-day moving average in isolation would have sold out, recognized capital gains, and ultimately bought back in at a similar price. Let history serve as a reminder.