Convergence

There are four commonly used moving averages used to gauge stock prices.  The 20 day (20MA) average is about a month’s market activity.  Common longer term averages used are 50, 100 and 200 days.  Why these particular numbers?  Why not a 60 day moving average or a 65 day average – about 3 months of market activity? In a high frequency trading environment of one minute intervals, a 200MA is about half a trading day. 

Whatever the reason, the movement of these averages triggers buying and selling decisions.  A long term investor may sell a stock when the price falls below the 200 day MA (9 months of market action), hoping to avoid a catastrophic crash in the stock’s price.  The reasoning is that something has fundamentally changed in either the company or the market if a stock falls below its 9 month average.  After a period of rising prices, a long term cautious investor or the manager of a pension fund who does not want to be whipsawed by daily price changes might wait till the 20 day MA crosses below or comes close to touching the 200 day MA before selling some holdings.  If the 20 day MA crosses back above the mid term 100 day MA, the investor or manager then re-enters the market.  They may have lost a few percent of profit but it is a relatively small “insurance” fee to protect against a more severe downturn and loss of value.

When these four common averages converge, it indicates that there is an underlying argument between short term and long term investors.  It marks a time of indecision, of conflicting economic indicators, and signals an impending move, either up or down.  These averages for the S&P500 index converged or clustered in September 2010, in December 2007, in August 2006, October 2004, April 2003, April 2002 and October 2000.

In September 2010, the market headed up after a summer of turbulent price swings.  This was precipitated by the Federal Reserve’s decision to introduce more stimulus by buying $600 billion of Treasury bonds over the following months.

December 2007 marked the end of a 4 year bull market and a gradual decline into the shock of the financial crisis.

In August 2006 another less turbulent summer ended and the bull market resumed its rise.  In October 2004, the market finally shook off its herky jerky range bound price action of the entire year and continued the rise that had started in April 2003, which was another convergence.  In April – May 2002, it started becoming apparent that the recession had not ended the previous October and the market started its descent after rising from the previous 9/11 lows. 

September – October 2000 marked the end of the strong bull market of the 90s.

When these averages converge, the prudent long term investor might do well to wait a few weeks to a month to see where the market is headed before making any portfolio shifts.  That initial move after the convergence usually signals where the market is going over the next year or several years.  Many sites have stock charts.  A free site with good charts is stockcharts.com.  They allow 3 moving averages overlaid on the price chart.  An ETF that captures almost all of the S&P500 index is SPY.

Convergences of 3 of these averages may accompany or occur near a convergence of 4 averages.  These usually signal a shorter term shift of sentiment that is not yet confirmed by economic and company earnings data.  A recent example was a minor cluster of the shorter averages in April 2009 when optimism about a stimulative recovery prompted some optimism that faltered slightly in June 2009 before the shorter term averages moved decisively above the longer 200 day MA.  An investor taking a long position (buying) at these minor convergences should be ready to exit their position if optimism proves unfounded. After the rescue of Bear Stearns in March 2008, a similar cluster of 3 rising shorter term averages in late May – early June of 2008 was not able to cross the long term 200 day MA in the weeks after the cluster.  This failure to confirm was a sign to the investor that something was amiss.  The following months proved the point.

The three shorter term averages of the S&P500 converged this past week, the shortest term averages shifting down toward the 200 day MA.   Stay alert during the coming weeks.

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