As an investor, it's easy to get caught up in the moment. Turn on CNBC, and the latest stock quotes streak across the bottom of your TV screen. Fire up your PC, and presto, you've got 24/7 access to every hiccup in the financial markets.
A steady stream of prices can look like random data points -- until you step back and take a longer view. You can get that perspective by turning those data into moving averages, which track the average price of a stock or an index over various periods of time. Such measurements smooth out short-term price fluctuations, allowing you to discern trends that develop over weeks, months, or even years.
These uptrends and downtrends can persist for a long while. Bill O'Neil, author of several books on stock investing and chairman of Investor's Business Daily, the national business newspaper, says that in studying the price patterns of thousands of stocks dating back 50 years, he found that once a stock became a market leader, it tended to remain in a strong uptrend for 18 months to two years. Downtrends can be equally persistent.
WEIGHTING THE NUMBERS. In this installment of Market Measures, a series on analytical tools that can help improve your investing acumen, we'll show how moving averages can help you identify promising stocks, avoid clunkers, and recognize when a stock may be running out of steam.
Moving averages come in several versions. The simplest adds up the stock's closing prices for a given period -- say, the most recent 10 days -- then divides by 10. The next day, you drop the first price in the series, add the newest price, and repeat the process. Some pros believe a stock's most recent prices are the most important, so they prefer to "weight" their moving averages. One widely used figure is the "exponential" moving average. It gives proportionately more weight to the latest prices in the series.
There's no need to do the calculations yourself. Many financial Web sites let you create customized charts that compare a stock's daily price to the site's moving averages. One of the easiest to use is Yahoo! (YHOO) (finance.yahoo.com), which lets you employ up to four moving averages spanning time periods from 5 to 200 days. Type in the ticker symbol, then click on Chart, Analysis, and Moving Average. At BusinessWeek Online, you can use the Stock Screener to search for stocks trading above their 50- and 200-day moving averages.
When a stock's current price exceeds the moving average, it's in an uptrend. Conversely, when the price is below the moving average, it's in a downtrend. When a price that's below the moving average jumps above it for a week or more, that's a signal the downtrend may be reversing. If a price that has been above the average falls below for a week or more, the stock's uptrend could be over.
TREND-SPOTTING. What time periods should you use for moving averages? There are no rules, but the 200-day moving average is popular because it captures relatively long-term price trends. O'Neil says he avoids stocks that trade below 200-day moving averages. Of course, he considers other factors when deciding whether to buy a stock. For instance, he looks for stocks whose sales and earnings have risen over the past 8 to 10 quarters. But unless a stock also trades above its 200-day moving average, "the market is saying the stock is a laggard," says O'Neil, and thus should be skipped.
Many investment pros employ both a 50-day and 200-day moving average. By simultaneously looking at a moving average spanning a short and a long period, you're likely to get a better reading of the trend. The relationship between the 50-day and 200-day moving averages can also provide important signals. For instance, many pros believe an optimal time to buy a rising stock is when its 50-day moving average jumps above its 200-day measure. "That's evidence that the uptrend is more than a blip," says Phil Roth, chief technical market analyst at Miller Tabak, an institutional brokerage in New York.
Roth points to Smith International (SII), which provides products and engineering services to the oil-and-gas industry. On Feb. 26, when the shares traded at $36.48, Smith's 50-day moving average sprinted above the 200-day level. The price has since gained 7%, to trade recently at $38.96, thanks to higher oil and gas prices. Another plus: Smith's price over the past several months has stayed above both moving averages. As a result, Roth figures Smith could climb to $44 to $46 in the next three months.
TIME TO TRADE. Qualcomm (QCOM) 50-day and 200-day moving averages tell a different story. In April, the wireless-equipment maker's shares fell below both of these measures. Since then, Qualcomm has lost 7%, to trade recently at $30.27. In another negative sign, its 50-day moving average is poised to slip under the 200-day level. Roth says the developing downtrend is a big reason he believes Qualcomm shares could trade as low as $26 in the next three months.
Moving averages can also help you to determine whether a powerful stock is petering out. Roth says his rule of thumb is that if a stock rises 15% to 20% above its 50-day moving average, it's likely to take a breather, either by trading in a narrow range for a while or experiencing a temporary bout of selling as investors who bought in at lower levels cash out. Look at eBay (EBAY), which has nearly doubled since October, to $96.60. On May 16, it closed at $99.19, 10% above its 50-day moving average. Roth thinks eBay is likely to trade in a fairly tight range of $87 to $100 for a while before resuming its uptrend.
You can also apply moving averages to stock market indexes, but you'll want to use longer time periods. Right now, investment pros are reading the tea leaves to decide whether a new bull market has begun. One positive sign, says Bernie Schaeffer of Schaeffer's Investment Research, is that the Dow Jones industrial average and the Standard & Poor's 500-stock index have traded above their 200-day moving averages since April. However, because these indexes spurted above their 200-day averages for several months last year before edging lower, Schaeffer says he's not convinced that we're in a new bull market. Further proof, he says, would be the indexes climbing above moving averages that measure a longer period of time, say, 40 months. The Dow, recently at 8493, would have to get above 9750 to clear that hurdle, while the S&P, recently at 921, would need to rise above 1165, Schaeffer says.
Trading a stock just because you like the way the moving average is going isn't a good idea. But if you're familiar with a stock's fundamentals, its moving average can help you decide whether now is an opportune time to buy or sell.
This is the fourth in a series showing how various Market Measures can help you identify opportunities and avoid traps By Susan Scherreik