Is A Drop Below The 200-day Average A Reason To Sell?

&l;p&g;The 200-day moving average (MA) of the S&a;amp;P 500 received plenty of attention across financial television networks yesterday. The S&a;amp;P 500 dropped below its 200-day MA at 2589 at 11:40 AM, and by 2:10 PM the S&a;amp;P had dropped to a low of 2553.&a;nbsp; It rallied for the rest of the day to close at 2581, but was still down 2.23% for the day. The Spyder Trust (SPY), which tracks the S&a;amp;P 500 (SPX), had similar price behavior.

&l;img class=&q;dam-image getty size-large wp-image-941125780&q; src=&q;×0.jpg?fit=scale&q; data-height=&q;640&q; data-width=&q;960&q;&g; NEW YORK, NY – APRIL 2: Traders and financial professionals work on the floor on the New York Stock Exchange (NYSE) ahead of the closing bell, April 2, 2018 in New York City. The Dow Jones industrial average was down nearly 450 points at the close on Monday afternoon. After several Twitter attacks from President Trump, Amazon stocks continued to fall. (Photo by Drew Angerer/Getty Images)

But what does the violation of this widely watched level mean to investors? In almost forty years of following the financial markets, I have found that those who act based just a moving average can easily get into trouble.

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While the SPX shows Monday&a;rsquo;s close below the 200-day MA (point 3), the 200-day MA continues to rise, which is a positive sign. The SPX also dropped below the 200-day MA at 2539 on February 9&l;sup&g;th&l;/sup&g; (point 2) but then closed at 2619, which in my view completed a short-term bottom (&l;a href=&q;;&g;Are The Wall Street Strategists Finally Right?&l;/a&g;). Since the February 9&l;sup&g;th&l;/sup&g; low, the 200-day MA has risen from 2539 to 2589, which indicates a positive trend.&a;nbsp; On Friday, November 4&l;sup&g;th&l;/sup&g; 2016 (point 1), the SPX closed at 2085, which was just above the 200-day MA at 2083 (point 1). In each of these instances, the &l;a href=&q;; target=&q;_blank&q;&g;advance/decline line&l;/a&g; had previously made a new high.&a;nbsp; This was a positive sign, as it indicated the market&a;rsquo;s weekly trend had not changed.

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The situation was much different in 2015, as, after a series of new highs, the A/D line formed a bearish divergence in May (line a). The A/D subsequently dropped sharply in June, beginning a new downtrend that confirmed the divergence. When the S&a;amp;P rebounded in June (point 1), the A/D line was much lower.

The SPX closed below the 200-day MA for two days in early July (point 2) before it rallied back towards the previous high.&a;nbsp; Once again, the A/D line formed lower highs on the rally and soon dropped to new lows. This reinforced its downtrend. SPX held above its 200-day for the next three weeks before it closed below it on August 20&l;sup&g;th&l;/sup&g; 2015 (point 3). Just four days later, the SPX had already dropped over 10% (point 4).

The gap between the SPX and its 200-day MA was very large, which was a sign that the market was very oversold. The rally in October took the SPX well above its flat 200-day MA, and even though the SPX peaked less than 1% below the May high, the A/D line was much lower.

This was also the case in early December 2015 (point 5), as the A/D line just reached its downtrend (line a) before it again turned lower.&a;nbsp; This set the stage for the sharp market decline in early 2016.

By early March 2016, the downtrend in the A/D line was overcome, even though the SPX was still below the 200-day MA. A week later, SPX crossed above its 200-day MA, and by the early part of April, the A/D line had moved to a new all-time high.

The price action in relation to a market&s;s 200-day MA can be very useful to look at. However, as the two examples above show, more information is needed in order to assess the overall health of a market. If you react to a move above or below the moving average by buying or selling, without looking at other data, then you are likely making an uninformed decision.&a;nbsp;Looking at&a;nbsp;the crossings of the 200-day MA, along with the A/D line analysis, is necessary to get a full picture of market health and avoid knee jerk reactions to isolated data points.

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