A Supplemental Note on MACD

This note is a supplement to the one below it. I felt it may be useful to show how MACD can be an effective tool on more than just a daily chart of a stock. MACD can be used on any time scale chart and works with indexes in addition to individual stocks. Below is a monthly chart of the S&P 500. The chart covers the period from late 1996 until the present. During that period, the S&P has crashed twice. One was the .com bubble burst that lasted from 2000 until 2003 and the other was the mortgage crisis crash that took place mostly during 2008.

Remember, usually the MACD histogram bar chart and the stock price chart move in the same direction. That is, if the stock price is going up the MACD histogram is going up and vice-versa. If they are moving in opposite directions, this is a signal that the a directional change may occur in the stock so that it will again be moving in the same direction as the MACD histogram. In those situations, the MACD histogram is a leading indicator. It gives you an idea of what the price of the stock or the index may do in the future.

Sadly, the MACD histogram did not call the bottom of the 2008 market crash. There was no divergence in the MACD histogram and the S&P price to give a signal. The MACD line crossing the signal line did serve as a useful indicator, but it was a lagging indicator. There was already a substantial recovery occurring in the S&P before MACD gave any signal of it. However, MACD divergence did make an accurate and timely prediction of the market top in 2000, the turnaround in 2003, and the market top in 2007. I'm going to discuss the 2003 turnaround and the market top in 2007 because they are the easiest to see.

The first market top occurred in 2000. From that point you can see that the S&P fell from about 1550 to roughly 765 (a downtrend) between the years 2000 and 2003. During that period, the MACD histogram had a pretty deliberate trend moving from the negative to the positive (an uptrend). In early 2003, the MACD line crossed over the gray signal line and the histogram turned positive. From that point, the market continued its trend upward until late 2007. However, the MACD histogram had been trending down towards the negative and finally went negative with the MACD line crossing below the gray signal line in late 2007.

In both situations, people paying close attention to the MACD on the monthly S&P 500 chart would have had a pretty good chance of catching both the bottoms and the tops of the market. Technical investors like to see confirmation of a signal. In the case of the 2007 market top, not only was the MACD signaling that things were going to make a turn for the worse, there was also a "double top". Do you see how the market basically topped out in 2007 at the same point it did in 2000? This is a very common chart pattern that technicians look for, but I'll save further discussion on that topic for another time.

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.

A Note about Support and Resistance

Modern economic theory is based on the idea that the market moves in a random walk. That is, the movement of the market and the stocks that comprise it cannot be predicted. In contrast, most experienced stock traders believe that the psychology of the market can be interpreted through its price action. One of our core beliefs is that close attention should be paid to technical trends. If a price movement has a certain sentiment behind it, there is a good chance that the stock will move in a predictable fashion. Technical analysts look for what they call "high probability" trades or outcomes. Who is one to believe: the efficient market economists, or the technical traders? The Federal Reserve Bank of New York weighed in on the matter:

"Technical analysis, the prediction of price movements based on past price movements, has been shown to generate statistically significant profits despite its incompatibility with most economists' notions of "efficient markets." Federal Reserve Bank of New York, C.L. Osler and P.H. Kevin Chang, Staff Report No. 4, August 1995.)

Support and Resistance are among the most basic forms of technical or chart analysis. I felt that this would be a good topic to cover today since support played an important role in the recent market downturn that happened last week. Many stocks that PMC tracks had long term support break down last Thursday or Friday. I'm going to focus on one of those stocks for this article.

This is a daily candlestick chart of Google Inc. from March 2009 until January 22, 2010. Please click on the image to see the entire chart.

This is called a candlestick chart. The red candles represent down days and the green candles represent up days. The bottom white line I have drawn represents where the support of the stock is. Support means that the stock is not likely to break below that area unless there is some change in sentiment. The support exists because there is sufficient buying demand at these levels to overcome selling pressure. The upper line represents where resistance is in the stock. This is where the stock is unlikely to break above unless there is some sort of change in people's opinion of the stock. This is the point where selling pressure overcomes the buyers of the stock. When the support and resistance are both trending upwards in this fashion, it is called an ascending channel. Each time the stock bounces off of the support or resistance traders notice, it reconfirms the support, and makes them all that much more difficult to break out of the next time.

You may ask, why does the stock haves support and resistance? Likely, some of it has to do with self-fulfilling prophecy. Humans are pattern recognition machines. When many people see the same pattern in the stock chart they may react in the same way. There are other reasons such as automated trading programs utilized at large institutions, people's propensity to focus on even numbers, or any other number of reasons. Ultimately, it doesn't really matter why it works just as long as it does.

As you can see in the above chart, Google stayed in its channel for nearly eleven months. There are a few different strategies that could have been successfully employed with Google over this time period. Since the channel was ascending, the most logical strategy would have been to purchase the stock in March or after the support had been confirmed and held onto it until the support level was broken on January 22nd.

So why after 11 months did Google drop below its support level (as shown in the circled portion of the chart)? On January 21, 2010, Google reported their quarterly results and the market reacted poorly to the news. The quarter's results changed the investors sentiments about the stock and thus there were no longer enough buyers at the support level to keep the stock elevated to that level. When a stock breaks below a major support level, often they fall to the next major support level. Major moving averages of a stock are often seen as support levels for stocks. The yellow line on the chart represents the stock's 100-day moving average. Once traders saw that Google had breached its previous support level, there was a high probability of the price falling to a major moving average. The 100-day happened to be the closest to the support level, and so one could have shorted the stock until the price reached the 100-day moving average and then covered their short with a relatively high probability of success. As you can see, Google closed almost exactly on the 100-day moving average.

Before investing in stocks, we recommend looking at both longer term and short term charts to determine where major support and resistance levels exist for a stock. Generally, it is not wise to buy a stock near its resistance level. On the other hand, buying near a major support level can give you some confidence that you bought the stock for a good price. However, nothing is certain. Many people bought Google on January 20th assuming that it would move back up after hitting its resistance level, but unluckily for them, this happened to be the time that the stock broke down below its support because of the change in the sentiment of the stock.