A few weeks ago I wrote an article titled "If Past is Prologue (then Look Out Below)", which portended some very unfavorable developments for the stock market over the next several years. And just as I had hoped, the stock market responded by moving inexorably higher day after day after day (aha, my plan is working!). So I almost hate to jinx things by writing about a recent bullish development. But hey, I have to write about something!

The Moving Average

Moving averages are possibly the most commonly used technical trading tool. And they do in fact serve a useful purpose. Looking at a given moving average helps one tell the forest (the trend) from the trees (the day-to-day price fluctuations). The problem is that in most cases there is no "optimum" moving average value or values that will automatically allow a trader to mechanically generate profits. Still, as with most things related to the financial markets, there are anomalies and exceptions to every rule. So let's look at one interesting such case (okay, well at least it is interesting to me, and yes, Hi, my name is Jay and I am a market geek. To those who fit the profile, the proper response is "Hi Jay." You know who you are).

The Golden Cross

As you can see in Chart 1, in early July 2009 the 50-day moving average for the Dow Jones Industrial Average crossed above the 200-day moving average. While there is nothing magical about this event, the fact of the matter is that the stock market has shown a strong tendency in the past to advance after this event takes place. To wit, in a recent article on Optionetics.com, Jordan Craw of the Hubb Financial Trading Tutors Team, highlighted a test done by Birinyi and Associates. According to that research, since the 1929 crash there have been thirty-six "50/200 golden crosses' on the daily chart for the Dow Jones Industrial Index. 72% of the time the market was higher 12 months later for an average gain of 10.44%. Over those 12 months the average peak was 17.89% higher than the signal date and the average trough was 9.79% lower.

This appears to be one case where a purely mechanical approach using moving averages seems to work pretty well over the long haul.

Chart 1 - Dow Jones Industrial Average 50-day MA moves above 200-day MA
click here for larger view

Chart 2 goes back even further and displays the growth of $1,000 invested in the Dow Industrials since 1900 only when the 50-day moving average is above the 200-day moving average. When the 50-day is above the 200-day a long position in the Dow is entered. When the 50-day average crosses below the 200-day average then the system moves to cash (for this test we assume a nominal rate of interest of 1% per year).

Chart 2 - "Golden Cross" Method (blue line) versus Buy-and-Hold Method (red line) using the Dow Jones Industrials Average (1900 to 2009)

As you can see in Chart 2, over the long haul this method has vastly outperformed a buy-and-hold approach. For the record:

• $1,000 invested in the Dow using a buy-and-hold approach from August 1900 through July 2009 grew to a little over $157,000.
• $1,000 invested using simple rules stated above grew to a little more than $419,000 in the same timeframe.

That's the good news. The bad news is that these past results in no way guarantee that the latest signal will be a winner. In other words, just because the long-term results have been good, this tells us nothing about how the latest signal will ultimately perform (although it is off to a heck of a good start).

Summary

In any event, investors would do well to keep an eye on this simple measure. As long as the 50-day average holds above the 200-day average, then a bullish stance appears to be warranted. However, if the market moves lower and the 50-day drops back below the 200-day, then another down leg may be unfolding and investors would be wise to heed that warning and play some defense.

Hey, it doesn't have to be rocket science.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.