Taking A Technical View Of The Stock Market: History Is On The Short Side (Bearish MACD Cross)
Thursday, 27 Apr 2023 10:00 PM
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This post comes after a day when the Dow Jones Industrial Averages notched its best day since January, the S&P500 rallied close to 2%, and the Nasdaq Composite led the herd with a close to 3% gain. However, a responsible investment manager has to be positioned correctly before these moves happen, not so much to follow them after they have happened. We are of the view that the move will very soon run out of steam, followed by a substantial leg down in the market. In this post, we examine a reliable technical indicator and how reliably it has predicted downturns in the past.
The Moving Average Convergence Divergence (MACD) indicator is a popular technical analysis tool used by traders and investors to identify market trends and potential reversals. The MACD indicator consists of a MACD line and a signal line. The MACD line is calculated by taking the difference between two Exponential Moving Averages (EMAs) of a security's price, typically a 12-day fast EMA and a 26-day slow EMA. The signal line, on the other hand, is a 9-day EMA of the MACD line. One of the key signals generated by the MACD is the bearish crossover, which occurs when the MACD line falls below the signal line. In stock trader's book, this very often suggests possible downtrend to follow.
Here are a few examples of the MACD crossover events for the S&P 500 index in 2022. The MACD indicator is displayed at the bottom, while price action is displayed on top. The bearish crossover events are marked with a vertical line. Note every time the bearish MACD cross over occurs, price action was negative.
We examined all bearish MACD crossover events in the S&P500 going back to the end of 2018, and identified a total of 33 bearish MACD crosses. We analyzed the S&P 500 price action in terms of drawdowns, trading days to reach the low point, and the percentage change from the cross (on the MACD indicator) to the low (in the price action). Here's what we discovered:
- On average, it took 8.33 trading days for the S&P 500 to reach its low point after a bearish MACD cross, with a minimum of 1 day, a median of 4 days, and a maximum of 37 days.
- The average drawdown from the bearish MACD cross to the low point was 5.73%. The smallest drawdown we observed was 0.55% while the largest drawdown was a whopping 32.72% (Covid onset in March 2020). The median drawdown was 3.91%.
- Notably, 100% of the bearish MACD cross events led to declines in the S&P 500 index, indicating a strong association between these crosses and market downturns.
Why did we spend a lot of time studying the reliability of this bearish MACD crossover signal? In case it hasn't been obvious, the S&P500 index has recently printed such signal. Historical data (well, at least data from the past 33 events) suggests an average drawdown of 5.7% to be expected, occuring over an average of about 8 trading days. We have just completed day 3 of the drawdown, making a small 0.55% decline from the signal crossover. The case has gotten muddier after today because the S&P 500 printed a strong green candle. However, there's still a couple more trading days ahead to see what's in place. Regardless, we believe there is more risks here than rewards, at least until after the MACD makes a bullish cross over (above the signal line).
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