Watch the trend to see where markets are likely headed
There have been no dramatic changes in market activity over the past week. Wall Street is still trying to sort out what the Federal Reserve is going to do with the economy and until traders and investors have a better idea of what will occur, stocks are likely to continue to fluctuate wildly.
One thing for investors to keep in mind is that Wall Street generally takes a pessimistic view of the economy. Rarely are traders surprised by negative events in the marketplace. Anticipated negative occurrences are priced into the value of stocks well ahead of the actual announcement, in most cases.
Wall Street has been aware of the problems in the sub-prime mortgage market for more than a year. The recent problems were not a surprise to traders. So we can expect that Wall Street has already discounted stocks to account for most of the expected damage. So while major indices will still retreat on days when there is negative news, we can also expect significant market gains when the news is positive. Of course there are many factors that can influence the markets in addition to the mortgage industry. But right now, that is the sector that is garnering the most attention.
In these weekly commentaries I refer frequently to moving averages. Moving averages (MAs), are one of the simplest and most basic tools of technical analysis. They also happen to be among the best tools. Today I want to give an example of how an investor can use a simple MA to help make investment decisions.
Let’s start with a basic definition of a MA from Wikipedia: “In statistics, a moving average is one of a family of similar techniques used to analyze time series data. It is applied in finance and especially in technical analysis. It can also be used as a generic smoothing operation, in which case the raw data need not be a time series.”
In the case of investments, the time series of data being considered is the price. There are actually many different kinds of MAs: exponential, weighted, central, and prior, for example. But for the purposes of this explanation, we are only going to discuss a simple moving average.
The black line on the chart below shows the daily closing price of one of the funds in our Foundation Strategy, the Fairholme Fund (FAIRX). The blue line is a 200-day MA for that fund. The gold line is the Nasdaq, included for comparison purposes only.
As mentioned in the past, my main consideration in choosing an investment is the direction and duration of its trend. In other words, I like to buy funds or stocks that are going up and have been going up for a long time. For me, a 200-day MA works very well in helping to identify funds that are in long-term trends. In this case you can see that FAIRX reached its 200-day MA in the most recent correction and then rebounded. The same occurred in the correction during the summer of 2006. The last time this fund was below its 200-day MA was in the first quarter of 2003–that’s a long upward trend.
For many investors a 200-day MA is too long for their tastes. They prefer something shorter–sometimes much shorter. I know day traders who spend a lot of time watching three, five and seven-day MAs. The shortest MA I usually utilize is 50 days. A 50-day MA is more practical when investing in volatile funds. For example, if you are using a short fund to hedge a long position a 50-day MA or even a 35-day MA makes much more sense than something longer.
A 50-day MA is also useful when deciding to re-enter a position that you sold to manage risk. For example, if FAIRX had broken down through its 200-day MA on the last correction and I had sold to minimize downside risk, I would have used a 50-day MA to determine when to buy back into the fund. Once a new rally was underway, the 50-day MA would help me capture more of the advance, as long as other indicators confirmed that the rally was genuine.
If you are interested in the mathematics behind moving averages, do an internet search and you can easily find formulas for every kind you could imagine.
Have a great weekend and enjoy the onset of fall. It’s still unseasonably hot here in Utah, but the leaves are changing colors at higher elevations in the mountains.
F.S.
If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group. This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call me, Flint, at 800-279-3377.