MW Stocks in the 'danger zone'? Here's what breaking a moving average really means.

By Mark Hulbert

A moving average is not the bearish omen it used to be

The S&P 500 slid below its 200-day moving average on Monday into what many stock-market technicians see as a "danger zone." But in truth, breaking below a moving average is not the bearish omen it used to be.

That's a huge relief, since the S&P 500 SPX has broken below many widely followed moving averages over the past two weeks. It broke below its 50-day moving average on Feb. 24 and fell through its 100-day moving average on Feb 27.

Up until the early 1990s, these breaches far more often than not meant the market's trend (short, intermediate or long term) had turned down. The opposite has been the case since then, as you can see from the chart below.

The chart focuses on the 50-day and 200-day moving averages, which are the moving-average lengths most widely followed by technical analysts. But the same pattern emerged with moving averages of all other lengths that I measured. (The returns plotted in the chart do not take transaction costs into account.)

What happened in the early 1990s to cause moving-average timing systems to start failing so spectacularly? The most likely culprit, according to Blake LeBaron, an economics professor at Brandeis University who has extensively studied various technical analysis indicators, are exchange-traded funds. It was in the early 1990s that broad-market ETFs first became available - enabling investors to cheaply and easily trade into and out of the stock market as frequently as they might want.

This effectively killed the moving-average trading strategy. Prior to the early 1990s, it was a lot more difficult and expensive to trade into and out of the market on moving average signals. Consider the period from the mid-1970s through the early 1990s, when open-end index mutual funds existed. Though these open-end index funds made it somewhat easier to trade into and out of the market with a single transaction, many of them charged transaction fees and/or placed restrictions on the frequency of transactions.

It was even more difficult and expensive to trade into and out of the market prior to the mid-1970s. No index funds or ETFs existed, and brokerage commissions were set by law at prohibitively high levels. Imagine in those earlier years that your portfolio held the 500 stocks in the S&P 500 and you just received a sell-signal from your moving average system. You would have had to call your broker on the telephone and enter 500 individual sell orders, paying for each of those transactions. The impressive market-beating gains generated by those systems were hypothetical only.

Lessons for investors

There's a general investment lesson to draw from these experiences: Profitable trading strategies don't work forever, especially as more and more investors know about the strategies and are readily available to act on them.

In this regard, LeBaron added, it's revealing that it wasn't just in the stock market that moving-average systems stopped working in the early 1990s. They also became far less profitable in foreign-exchange markets as well. Since the equity and currency markets are not linked in any obvious way that could explain why moving averages would fail simultaneously in both, this reinforces the conclusion that ease of trading is the culprit.

A fascinating academic study in this regard appeared several years ago in the Journal of Finance. Entitled "Does Academic Research Destroy Stock Return Predictability?," the study was conducted by R. David McLean of Georgetown University and Jeffrey Pontiff of Boston College. They studied 97 stock-market indicators that prior academic research had concluded were able to identify stocks that could beat the broad market. They found that trading strategies based on these indicators were 58% less profitable after the publication of the journal articles that reported their existence.

No wonder beating the market is so difficult.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

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-Mark Hulbert

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March 10, 2025 16:57 ET (20:57 GMT)

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