REVIEW OF 13- AND 34- PERIOD EMAS -- MOVING AVERAGES PROVIDE OBJECTIVITY, SIMPLICITY, AND DISCIPLINE -- SO FAR, NO SELL SIGNALS HAVE BEEN GIVEN
REVISITING 13 AND 34 PERIOD EMAS ... I've written several past articles about a moving average system that has a remarkable track record. It's a combination of 13 and 34 period exponential moving averages. I use the word "period" because that EMA combination works in all three time dimensions -- daily, weekly, and monthly. [Exponential moving averages give more weight to recent prices and are more sensitive to simple moving averages that give equal weight to each price]. Chart 1 plots the 13 day EMA (blue line) and the 34 day (red line) on the S&P 500. Short-term buy and sell signals are given when the two lines cross. The last short-term sell signal was given in late February, which reversed back to a buy signal in late March (see circles). The black line on top of Chart 1 plots the "difference" between the two EMAs. A move below zero is a sell signal, while a move back above zero is a buy signal (see arrows). [That line can be created by using 13, 34, 1 on the MACD Indicator]. The black line has started to dip, which suggests that the two EMAs are starting to converge. That's a hint at some short-term loss of upside momentum, but doesn't qualify as an actual sell signal.
Chart 1
WHY CONVERGENCE MATTERS ... Chart 2 shows how the black line (EMA difference) worked over the last two years. The chart shows three short-term sell signals when the black line fell below the zero line (which means that the 13-day EMA crossed below the 34-day). Each sell was followed by a buy signal when the black line moved back over zero. In the ongoing uptrend, the sell signals were relatively mild and short-lived. [We're never sure, however, when a short-term sell will turn into something more serious]. The main point of Chart 2, however, is to show that the black line starts to drop well before an actual sell signal is given (see arrows). In some cases, that divergence lasts for several months. But it's usually a sign that the market rally is in need of correcting. This is the first time the black line has started to drop since last October. That's more of a warning than an actual sell signal.
Chart 2
WEEKLY EMAS ARE STILL UP ... Chart 3 shows the same the same two values (13 and 34 EMAs) applied to a "weekly" chart of the S&P 500. [I've deleted the bars for the sake of clarity]. Remarkably, the two weekly EMAs have given only two signals in the last seven years. The first was a sell signal in late 2000 (top red arrow). The second was a buy signal in the spring of 2003 (top blue arrow). The black line below Chart 3 is the difference between the two EMAs. The crossings above and below the zero line in 2000 and 2003 correspond with the moving average crossings (see arrows). At no time in the last four years has the 13-week EMA crossed below the 34-week. And, at no time has the black line fallen below zero. It came close in 2004, 2004, and in mid-2006. Each time, however, the zero line held and the uptrend resumed. At the moment, the two lines are still positive. And the weekly difference is still rising. One could argue that the difference line is up against its early 2004 peak and overbought. Chart 4 shows the actual EMA lines. Although the difference (black line) is also testing its early 2007 peak, there's no sign of downturn so far.
Chart 3
Chart 4
MONTHLY EMAS STILL POINT UP ... Chart 5 overlays the 13- and 34- "month" EMAs on the S&P 500 (blue and red lines respectively) since 1990. Only two EMA crossings took place in that time. A major sell signal in 2001 and a major buy in 2004. [The 2001 sell signal was the first signal since a buy in 1982]. The problem on this chart is that the EMA crossings came almost a year late. [Monthly signals are always the slowest]. I think the best way to compensate for that is to focus on major turns in the difference (black) line itself. The black line turned down in 2000 (red arrow) and gave an early sign of trouble. By contrast, the black difference line turned up in early 2003 (blue arrow) a year before crossing over its zero line. The moral there is to pay attention to turns in the black line. At the moment, that line is still rising. An even more sensitive way to use the monthly lines is to watch the price action versus the faster of the two EMAs. Chart 6 plots the 13-month EMA on monthly S&P 500 bars. The first sign of trouble is a price drop below the blue line. The second is a downturn in the blue line itself. So far, neither has happened. The only cautionary note at the moment is the fact that the S&P is testing its 2000 high and is somewhat overbought.
Chart 5
Chart 6
WHY USE MOVING AVERAGES? ... In my earlier days as a trader, I made heavy use of moving averages to generate buy and sell signals. In fact, the mainstay of most mechanical trading systems is some combination of moving average lines. The reason for that is discipline and simplicity. Signals are relatively easy to spot. The decision to abide by moving average signals also imposes discipline on a trader. That's something that can't be underestimated. Moving averages aren't perfect. One of their shortcomings is that don't catch exact tops or bottoms. That's why we combine short-term averages with longer-term ones to eliminate time lags between turns in the market and trading signals. I divided my portfolio into short and long-term positions. In other words, I would commit the "trading" portion on short-term signals. I would await signals on weekly and monthly charts, however, before moving on longer-term holdings. In the current environment, for example, a short-term sell signal (which hasn't occurred yet) would justify some profit-taking. A sell signal on the weekly chart (or some deterioration on the monthly) is necessary before doing more serious selling. Doing things gradually (or in stages) also eases the burden of making major decisions at one time. Some moving averages give false signals on occasion. The 13- and 34- period EMA, however, gives much fewer than any other moving average system that I've studied.
