The 200 day average is usually considered as a key indicator to tell if markets are bullish or bearish. But can this be proved statistically, or is it just an urban legend handed down from one generation to the next?
Let’s do some studies and find out.
The 200 day moving average
Looking at the chart of the S&P500 index and it’s 200 day average let’s me think that the 200 day average is actually a useful indicator to separate the bull and bear phases of the market. But the eye tends to see what the brain is looking for, so you might have focused on the crash 2008 and the bull market afterwards, but have ignored all these little breaches below the 200 day moving average which happened in between. As a trader I can`t make any money with knowing that there has been a long period under the 200 day average, i need to make my decision as soon as the market drops below the 200 day average.
Distribution of returns above and below the 200 day moving average
The chart above (on the right side) shows the returns distribution of 10 day returns. The green distribution represents the 10 day returns if S&P500 is trading above it`s 200 day moving average, the red line represents the 10 day returns returns when the market is trading below its 200 day moving average. Data from 1980 up to now has been used.
What are the curves telling us?
The first thing to notice is, that the red line distribution, representing the returns below the 200 day average, is way wider than the distribution of returns above the 200 day moving average.
The second thing to notice is the sum of probabilities lines. As you can see both cross 1 at the same place. This just means, that the distribution above and below the 200 day average has got he same median. You do not have a higher probability for a positive return if you are above or below the 200 day moving average. That’s quite unexpected! The only thing which is different below or above the average is volatility! If the market trades below the 200 day line you will most probably experience bigger equity swings, but the chance or a positive or negative 10 day return stays the same.
Equity vs. Forex markets
As this finding has been quite surprising for me, I tested it with several equity indices and single stock data. It seems that this is an universal characteristic to equities, maybe founded in the strong bullish market data.
A different picture can be seen when testing forex data. The chart above, the one on the right side, shows some quite different behaviour. It is based on EURUSD data since 1980 (FX basket before 2000).
EURUSD shows the behaviour I would have expected. The returns below the 200 day moving average are shifted to the left, like the sum of probabilities is. This means that with forex you actually get more negative returns when under the 200 day average.
Better test, as it can reveal some unexpected results. In Equities the 200 day average seems to be a good indicator for volatility, not for direction. With forex ist seems to predict direction, not volatility.
Link: an article by Ben Carlson about a similar theme