Using MACD To Identify Long Term Trends
How can we tell whether a downturn is just a normal part of a solid bull market, or the beginning of a major downdraft? We need to have a way to identify when long-term trends are changing.
One way to guard against being caught on the opposite side of a trend is to apply technical indicators that can isolate major trend shifts and reduce psychological biases. Specifically, technical indicators based on moving averages reduce the noise that characterizes the stock market.
We can argue about the fundamental valuation of a company, but we cannot argue whether a stock’s price is above or below historical moving averages. In analysis based on moving averages, the focus is less on why the market should move up or down, and more on what the current market dynamics are from a supply-and-demand perspective.
Today there are more opportunities than ever for a decoupling of price from fundamentals. This is fueled in part by retail investors, who have access to information and tools that previously were available only to institutional investors, and social media in which market players can talk up stocks.
This is where MACD, or “moving average convergence-divergence” indicator, comes in. It was developed in the 1970s and is widely accepted by technical analysts as one of the best ways to identify prevailing trends. It is available on just about every charting platform, most of which allow for revision of the indicator’s standard parameters.
The standard MACD consists of a spread between the 12-period and 26-period exponential moving averages of a stock’s closing prices, which is then smoothed by a signal-generating line derived from the 9-period exponential moving average of the spread.
A long-term trend-following overlay is afforded by the MACD applied to the monthly bar chart of the S&P 500 Index (SPX). It provides a visual gauge of the primary trend, and it identifies major turning points when the two lines that comprise the MACD cross over. The crossovers provide “buy” signals and “sell” signals that may more clearly indicate when the long-term trend has shifted.
To illustrate this, the chart goes back 1999. The price bars are colored green to reflect positive or improving MACD readings, and red to reflect negative or deteriorating MACD readings. Bullish and bearish crossovers are denoted by up and down arrows. Generally, it has been good to be long equities when the bars are colored green, which has typically been associated with uptrends. It tends to be a more difficult environment for investors when the bars are colored red, which is typically associated with a sideways or lower trend.
It was 2008 that technical analysis really became noticed on Wall Street. The SPX had seen its monthly MACD flash a “sell” signal in November 2007, a month before it broke down, and it did not flash a “buy” signal until a few months after the March 2009 low. The bearish reversal caught many off guard, but those who used the MACD were quicker to minimize exposure, bringing attention to the field of technical analysis as a viable discipline for risk management.
MACD “buy” and “sell” signals do not capture pivots until after-the-fact, but the signals are not too late to take advantage of long-term turnarounds. Sometimes they even precede bear markets, as in 2000 and 2007. Note that the MACD flashed a “sell” signal in January 2000, before the tech bubble burst, and did not flip to a “buy” signal until May 2003, before a sustained bull market move began.
Whipsaws are not uncommon, but they are short-lived, and often associated with shifting trends like in 1999 and 2015, so even false signals can have value. The bulk of uptrends and downtrends were captured by the MACD despite its inherent lag. The MACD is not a trading system, so a “sell” signal need not be interpreted as a reason to move to 100% cash in a portfolio, but rather an indication to position more defensively.
Traders often refine long-term MACDs with shorter-term MACDs, evaluating them alongside other momentum and overbought/oversold indicators for a holistic view. Since technical analysis is based on concrete data, there is broad agreement on the merits of MACD, although different preferences and parameters can be applied.
So, what does MACD tell us about the current environment? As it stands, the SPX is currently in a bear market cycle and has been since the MACD flashed a “sell” signal at the end of March 2022. Since the “sell” signal, the SPX is down roughly 16% and continues to trend lower. In a down-trending environment, breakouts are more likely to fail, and breakdowns more likely to see downside follow-through. Overbought readings instill fear, whereas oversold readings instill healthy skepticism.
Psychological biases, notably fear and greed, are what makes a market a market, and they can be managed with unbiased input from the MACD. Clear-eyed analysis of the underlying momentum of the market can help us stay on the right side of the prevailing long-term trend.
Adapted from “The New Market Momentum: Reading the Technical Indicators” by Katie Stockton, published on Future.com (June 15, 2021).
Katie Stockton, CMT
Founder and Managing Partner