It is amazing how moving average crossovers (MAC) seem to indicate trends in the stock market. One of the problems with MAC is that it inherently contains a lag factor. By the time you realize that the 20 day average is curving upward, you have missed out on a great opportunity to invest your money. I recently observed this when looking at the historical trending of the S&P 500 for the period of June 21, 2010 to July 12, 2010. On June 21st, the stock market crossed over the 20 day average line on its way down to a new low that had not been seen for some time. On July 6th, it begin a climb upward. Around July 10th, it re-crossed the 20 day average line. During that time it went from 1030 to 1075. That timeframe represented a missed opportunity.

One way around this problem is to trade with multiple moving averages. You will probably want to choose a long-term (50 day) and a short term (20 day) moving average. You should then watch for when these averages begin to move toward each other and crossover. Another good thing to watch for is when the stock price crosses over a moving average line. This is similar to what recently happened with the S&P 500 stock price. This is especially important when the moving average line encounters a support or a resistance point. If the case happens where the average tends to bounce off one of these support or resistance points, it can turn into a strong trend-reversal signal.

One of these crossovers is known as the Golden Cross. This occurs when the 50 day average crosses over the 200 day average. This can represent a major shift from the Bears to the Bulls. The Death Cross is when the 50 day falls across the 200 day average. This is an indication of a bearish sentiment. Moving averages do not work during sideways stock movement. They will do nothing more than give false signals. Moving averages will converge to a single flat line during dead, no price change markets. You will need to watch this scenario and not use them during this action.

Theodore Wong, a professor with Stanford, provided some empirical support for the MAC. In his paper he indicated that an investor should go long if the S&P 500 price is above the 200 day average and sell if it falls below the line. He studied trends dating back to 1871 to develop his theory. One of the underlying basis for Mr. Wong’s theory is the Rational Belief Equilibrium (RBE) which was also developed at Stanford University by Mordecai Kurz. RBE represents a significant advance in the study of asset market behavior. RBE can be used to explain why the stock market tends to move in cycles. The key ingredient in RBE is investors ignorance about the future.

Rather than making the assumption that investors behavior is always right, Mr. Kurz takes the position that investors often make mistakes. In Mr. Kurz’s model, market prices are flat-out wrong from time to time. There are significant world events such as 9/11/2001 or 12/7/1941 which will change the way investors look at the stock market and investing. No one can predict these events, so they cause ripples in the stock market.

RBE helps to explain why cycles occur, because it is a descriptive theory of how markets work that will justify a prescription of what we should do as investors. According to RBE, cycles will emerge whenever the mistakes that investors make become correlated. Bull and bear markets reveal themselves in the form of serial correlation. When conditions in an asset market today can influence likely conditions in the market tomorrow, then knowing something about recent conditions in the market can provide predictive value of what may happen next. Horace “Woody” Brock put it this way. “If it is cold in Kearney, Nebraska today, I can predict with accuracy it might be cold tomorrow. This phenomenon is known as Winter.” Bull and bear markets do have seasons and if an investor is astute enough to decipher them, they stand to be able to make money from their investments.

I would suggest you read the paper which can be found at http://www.capitaladv.com/media/pdfs/Advisor_Perspectives_Article_Sept_2009.pdf. There are also other papers which have been written on RBE. It makes for a fascinating read on stock market cycles and why they behave the way the do.

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Tags: cycles, Death Cross, efficiencies in the stock market, Golden Cross, MAC, make money, making money, momentum trading, moving averages, RBE, Stock Market