A Note about Moving Average Convergence Divergence (MACD)

Moving Average Convergence Divergence (MACD) is one of the most popular technical indicators used by investors. MACD is a trend-following and momentum indicator. In theory, trend following should not work. If the market were totally efficient there would be no trend to follow. However, in practice research has shown that trend following can produce average beating returns. There are of course many caveats. Trend following can result in "whipsaws" or false trends that do the opposite of what an investor anticipates. For this reason, PMC only uses trend following technical analysis for stocks that we already see value in. We use value investing for strategic stock selection and trend following mechanisms like MACD for tactical investment decisions. We believe that by only using technical indicators like MACD on stocks that we think are already mispriced, we lesson our chances of downside and increase our chances of upside.

MACD is composed of two lines. One is a signal line that is a 9-day exponential moving average. An exponential moving average is a moving average where more weight is given to the latest data. The other line is the MACD line which is determined by subtracting the 26-day exponential moving average from the 12-day exponential moving average. When the signal line crosses over the MACD line, this is a bullish indicator. when the MACD line drops below the signal line, it is a bearish indicator.

One of the most effective uses of the MACD is to look for stock price and MACD or MACD histogram divergence. A MACD histogram is simply a bar chart where each bar shows the difference between the MACD line and the signal line.

The above picture is an example using a recent daily stock chart from Nvidia Corporation. Please click on the chart to see a large version. In this chart there are two divergences between the stock price and the MACD histogram. The first is where the stock is trending down during the months of October and November while the histogram is trending up (the histogram is moving up towards 0 from higher negatives). Notice when the MACD blue line crosses the silver signal line, there is a jump in the stock price. Careful watchers of the MACD histogram divergence could have predicted this upward move. The second divergence is during the month of December and January. The stock price makes an unrelenting upward move while the MACD histogram is trending down towards 0. Once the MACD line crosses under the signal line, there is a long downtrend. I have also marked the support level of the stock given that support was discussed in a previous note.

As you can see, MACD can be an effective tool in predicting trends and momentum in a stock. Combining divergence in the histogram with the signal line improves the probabilities of the MACD's accuracy. PMC does not recommend that you solely rely on MACD to make investment decisions. We feel it is not accurate enough for those purposes. It should only be used as a supplemental tool to determine an entry or exit from an equity position.