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Janet in Trading psychology,

What breaking the 200-day moving average for stocks really means

It usually means bad news, but that’s not the case today

The breaking of the 200-day moving average means the stock market’s major trend has officially turned down.

Or does it?

It’s urgent that we find out, since the Dow Jones Industrial Average DJIA, -0.04%closed last week below this crucial technical level, and the S&P 500 SPX, +0.16% did so yesterday.

In fact, some technical analysts consider breaking below the 200-day moving average to be the official end of a bull market. So, at least according to this definition, we’re now in a bear market. (The usual definition is a 20% or more decline.)

The situation may not be that dire, however. While market-timing systems based on the 200-day moving average had impressive records in the earlier part of the last century, they have become markedly less successful in recent decades — to the point that some are openly speculating that they no longer work.

In fact, since 1990 the stock market has actually performed better than average following “sell” signals from the 200-day moving average.

This is well illustrated in the accompanying table. “Sell” signals were those days on which the S&P 500 dropped below its 200-day moving average after the previous day being above it; there have been 85 such occurrences since the beginning of 1990. The returns in the table reflect the dividend-adjusted return of the entire stock market (as judged by indexes such as the Wilshire 5000W5000, +0.28% ).

Next four weeksNext 13 weeksNext 26 weeksNext 12 months
Following ‘sell’ signals from 200-day moving average2.5%5.4%6.1%9.7%
All other days0.9%2.7%5.6%11.7%

To be sure, notice from the table that at the 12-month horizon, the stock market performed slightly below average following “sell” signals from the 200-day moving average. But, given the variability in the data, this difference in returns turns out not to be significant at the 95% confidence level that statisticians often rely on to conclude that a pattern is genuine.

By the way, the difference in 26-week (six-month) returns also is not significant. But the four- and 13-week results are quite significant.

Just consider the last time the S&P 500 dropped below its 200-day moving average — which was in November 2012, just after that month’s presidential election. The stock market almost immediately resumed its powerful rally, and the Wilshire 5000 was more than 3% higher in a month’s time, 12% higher over the next quarter, and 32% higher over the subsequent year.