A trio of averages to help you decide
How this trio can help you
CHARLES DOW, known as the originator of technical analysis, developed a theory around 100 years ago that’s still of value today. It includes a concept that a market cycle can be compared to the pattern of the ocean’s waves. The small waves breaking at your feet represent the daily fluctuations on the market. You can’t see what the big picture is. Then you have the medium-sized waves, which give you some idea of whether the tide is coming in or going out. But it’s the big waves that show the direction of the tide best of all.
In other words, in moving averages the small waves can be compared to the daily price fluctuations and the shortterm average (say four or five weeks); then comes the medium term (say 13 weeks); and finally the big one of (say) 40 weeks, which gives you a good indication of the market’s basic trend.
It was shown last week that it’s a very important signal when the 40-week average – after a bull market lasting quite a time – rolls over downward, because that can only happen when sellers (bears) are dominant over the buyers (bulls). That’s a danger signal, and that’s when the man in the street is active in the market. He’s very confident – because “everyone” is making money. Experienced market players know when that happens the danger signals are flashing and they unload overvalued shares.
The problem with the 40-week average is that its signals tend to arrive late. At the beginning of a bull market it could be so late a substantial portion of the cream may be gone. In the same way, a good deal of your profit can be lost when it turns around downward.
To avoid that, investors must look seriously at the relationship between the trio. Because, just like Dow’s waves, they flow into one another. The five-week average is the most sensitive (and unreliable) and will always give the first indication by turning around downward and falling to below the 13-week average. If it subsequently also falls through the 40 weeks then you can be sure there’s real selling pressure. However, it’s when the 13 weeks falls through the 40 weeks that you should become concerned. The bears are busy with a real attack.
There are expert investors who look only at the three averages. The share price is eliminated, because they believe it merely confuses them. The reason is that a price of especially a quality share seldom plummets or soars overnight. It’s usually a process giving you enough time to act.
Here I must emphasise something important: don’t rely only on technical analysis. After the market has experienced a major downturn, as in 2008, look only at quality shares – and any broker who knows what he’s doing will be able to advise you on that: those that have the potential to recover strongly. Because growing profits draw prices upward like a magnet. So when that upward turnaround occurs it’s merely a case of informed buyers seeing value in the share. Prices of quality shares are determined by the major investors – and they usually buy on the basis of good research.
When do you know they’re buying steadily?
An important early signal is when the five-week average crosses the 13-week and then the 40-week average. And when the 13-week average turns around upward it’s a signal we may perhaps be looking at a new trend. And when the 13-week average pushes through the 40-week average we can assume we have a new bull market. As long as it remains above the 40 weeks you should stay with that share.
The opposite is the case at the top of the market: when prices are high and value scarce. It’s not difficult to know when that’s the case. It’s a good idea to keep an eye on the media. You will receive ample warning, when the 13-week average falls through the 40-week average and the latter turns over downward, that the bear can cause you serious harm.