The popular narrative out there is that moving averages are a tool for identifying trends in the stock market. I’d argue they’re far less an indicator of trend, and far more an indicator of volatility. And with the S&P 500 recently trading back above its 50-day moving average in what could be a false signal, it’s worth considering what a whipsaw here might mean for traders and active allocators entering September.
You’d be hard pressed to find any investor or trader who hasn’t heard of a moving average. They are one of the most straightforward and widely used technical indicators. They are calculated by finding the average of a specific set of data over a certain period. The most popular moving average — the Simple Moving Average — is calculated by adding all the data over a specific lookback period, and then simply dividing that total by the number of days.
How Moving Averages Are Waving a Red Flag Now
Investors use moving averages in various ways. Most use them as trend indicators, helping investors identify the general direction of a stock’s price movement. However, as I noted in my 2016 Dow Award-winning paper “Leverage for the Long Run,” moving averages are more a “tell” on stock market volatility.
Usually, independent of which moving average lookback period you’re using, stocks are less volatile above a moving average and more volatile below.
To be clear, volatility refers to price variability and violence of price over a certain period. High volatility indicates that the price of the asset can change significantly – and quickly – up or down. This of course means that whipsaw risk is higher when entering a risk-off, high-volatility regime. Low volatility suggests that the asset’s value does not move around significantly and is far steadier.
This brings us to the recent behavior of the S&P 500. The index crossed below its 50-day moving average briefly, only to shoot right back up. Everyone claims that this is a bullish signal, but I don’t necessarily agree.
While investors typically see this as a bullish signal, if you factor in the outperformance of utility stocks, it could be a false signal. Therefore, stocks could cross back below the moving average sooner than later.
The Bottom Line
The bottom line here is that I think we are at an important juncture from a volatility perspective. If I’m right that we are close to a credit event due to the lagged effects of the fastest rate hike cycle in history, volatility in general should pick up. This would mean the S&P 500 goes back below its moving average. People would interpret this as a trend change, but it would be more appropriate to call it a new volatility risk-off regime.
While moving averages are a popular tool for identifying stock market trends, investors often overlook their role in understanding market volatility. As the S&P 500 continues to trade above its 50-day moving average, investors should remain cautious and consider whether this may be a false signal.
The next few days will be important to see how this plays out.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
