The 50-, 100-, and 200-day moving averages could help investors define the current market enviroment
Knowing the trading environment you are in is necessary for a couple of reasons. First, implications of a study can change depending on the environment. For example, bullish sentiment is less worrisome when the market is near all-time highs, compared to when stocks are falling. Second, expectations going forward can change depending on the stock market environment.
Defining an environment is often subjective. That's why I came up with a fact-based way to define the stock market environment. Below, I'll explain a method I use and dive into expectations going forward, based on historical returns.
Using Moving Averages to Define Environment
Simple moving averages are easy to calculate, and I have found them quite useful for defining an environment. Below is an example where I simply look at whether the 200-day moving average of the S&P 500 Index (SPX) was increasing (bullish environment) or decreasing (bearish environment).
The table below shows the one-month returns in those environments. The index is currently decreasing. Based on data since 1950, the SPX averaged a one-month return of 0.52%. That underperformed compared to times the moving average was increasing. The table shows you can also expect a slightly lower probability of a positive return and higher volatility.
Next, I'm using the same method to look at whether the moving average is increasing or decreasing. Instead of using just the 200-day moving average, however, I am also using the medium-term 100-day moving average and the short-term 50-day moving average. Our current environment is that top row, in which all three moving averages are decreasing, denoted by the red minus signs.
Historically, this environment has tended to underperform over the next month. The SPX averaged a 0.49% return in the next month, with 55.7% of the returns positive. Compare this to the typical return since 1950 of 0.74%, with 61.5% of returns positive.
Even worse news is that the next environment we'll most likely find ourselves in is where the 200- and 100-day moving averages are decreasing, with the 50-day moving average increasing (indicating a short-term rally within a long and intermediate term downtrend). Of the eight environments created using this method, it's the only one with a negative average return over the next month (-0.38%).
It is also the only environment which has had more negative returns than positive returns. The most bullish environment is the one we will find ourselves in, if we can withstand the bearish environment previously mentioned. In that environment, the SPX has averaged a 1.64% return over the next month, with 70% of the returns positive.
It's useful knowing the trading environment you're in. For example, I can break down those 2,829 historical returns from the first row of the table above based on sentiment, short interest levels, etc., and a study might come to a different conclusion compared to if I included the other environments.
Alternatively, just looking at the expectations going forward can be useful as well. If you are looking to buy into stocks, this analysis would suggest being wary about a short-term rally. Wait for confirmation in the form of an increasing 100-day moving average before being confident in bullish returns going forward.
Finally, the following table uses the same method, but instead of summarizing the one-month returns going forward for the SPX, it shows the average return over different time frames. In addition to the one-month average return, it shows the average for three, six and 12 months going forward.
While returns from our environment have underperformed in the one-, three- and six-month time frames, the one-year average return has been 10.5%, which beats the overall return and ranks second out of eight environments. Buy and hold investors have less to worry about than traders with a shorter-term timeframe.
