Understanding the Misconception behind Moving Average Crossovers and Stock Sell-offs
The phenomenon of stock sell-offs occurring when the 200-day moving average (MA-200) rises above the 50-day moving average (MA-50) has puzzled many traders and analysts. However, the assertion that these moving averages cause stock prices to drop is a misunderstanding of their function. This article aims to clarify the role of these moving averages in technical analysis and explain why stock sell-offs often occur following such crossovers.
Misconception: Moving Averages Cause Stock Prices to Drop
Traders often mistake the cause and effect when it comes to moving average crossovers. It is important to understand that moving averages are merely historical records, not predictive indicators. The crossover of the 50-day moving average below the 200-day moving average is indicative of recent price movements. In other words, if the recent price is dropping, the MA-50 will indicate a lower price compared to the price a few months or six months ago (MA-200).
The moving average line will simply drop if the recent price is dropping. The price does not drop because of the moving average signal; rather, the drop is due to the underlying change in market sentiment or economic indicators. However, traders who believe in the signal may accelerate the sell-off as they act on this signal, leading to a self-fulfilling prophecy that can further exacerbate the drop.
Predication and Inference
Technically speaking, for the 50-day moving average to cross over the 200-day moving average, the price must have already diminished significantly from its local high. This crossover signal is considered late in many traders' strategies as it often arrives after a sustained decline, suggesting a significant shift in the prevailing trend.
The crossing of the 50-day and 200-day moving averages does not predict what will happen in the future. It merely indicates a change in the trend that has already taken place. In essence, the crossing is a summary of past performance, not a sign of what to expect in the coming days or weeks.
Self Fulfilling Prophecy and Market Sentiment
The significance of moving average crossovers is often debated. Particularly, the 'death cross,' where the 50-day moving average falls below the 200-day moving average, is considered a strong market signal. However, the reality is that the market may move in such a way because traders believe in the signal and act upon it, rather than the signal driving the market movement.
For example, recent instances of a death cross such as Bitcoin on 6/25/21 saw a significant sell-off due to the broader market sentiment. Investor confidence in those stocks and/or cryptocurrencies going into the death cross would have been low, thus any negative news or events could lead to a sharp decline in prices.
Conclusion
Understanding the true nature of moving average crossovers is crucial for any trader or investor. These technical indicators are primarily reflections of past price movements, and should be used with caution as predictive tools. The sell-offs that often follow such crossovers are often a result of broader market sentiment and self-fulfilling prophecies rather than the crossovers themselves.
Traders are encouraged to use moving averages as one of several tools in their technical analysis kit, alongside other forms of analysis such as fundamental analysis, sentiment analysis, and news-driven events, to make informed decisions in the volatile world of the stock market.