Momentum indicators tell us a great deal about the stock market. These indicators can be a useful forecasting tool. But that might not be the way all investors look at these indicators.
Momentum indicators are designed to measure the strength of the trend. They are usually thought of as short term trading tools. This makes sense because momentum measures the strength of a move and if a stock moves too fast, or shows too much strength, a reversal should be expected.
That standard interpretation of momentum indicators is based on the fact that stock prices tend to exhibit mean reverting behavior in the short term. That means prices will move between overbought and oversold extremes in the short run.
Overbought means that the price move has been rapid and pushed momentum indicators to the upper limit of their range in a relatively short amount of time. Oversold means the opposite. It means that prices have fallen quickly, and perhaps they have moved too far, too fast. In either case, a reversal is expected.
Momentum in the Long Run
While short term analysis is useful for many investors, for others a longer term view could be more appropriate. For example, if an investor is focused on retirement several years away, investing could be thought of as a marathon race rather than a sprint. Even in a marathon, momentum can be helpful.
There are a variety of momentum indicators, the stochastics is among the most popular. One analyst described it in colorful terms:
“Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.”
Stochastics, and other momentum indicators, apply this idea to prices. Technical analysts generally believe that a close near the high is bullish and a close near the low is bearish. Stochastics quantifies this belief with the formulas shown below.
In the chart below, prices have been making new highs while stochastics has not. This could indicate momentum is slowing.
This is a chart of the SPDR Dow Jones Industrial Average ETF (NYSE: DIA). It is a monthly chart to develop a long term view.
Notice in the chart that the stochastic indicator made a lower high in 2007, before the bear market that pushed major stock market indexes down by more than 50%. Notice also that stochastics formed lower highs in 2014, ahead of a decline of more than 19% in DIA that began in 2015.
In 2015, the S&P 500 did drop by more than 20% but that is not considered an official bear market by many analysts and by the financial media because the Dow is used for official definitions of bull and bear markets. However, the signal from stochastics was still useful for investors.
And, at the right side of the chart it can be seen that a similar pattern is developing right now with stochastics making a lower high signaling that a significant decline in prices is likely.
Confirming Stochastics With MACD
To confirm that outlook it could be useful to consider the status of a second indicator. In this case we will use MACD.
Formally, MACD is the Moving Average Convergence-Divergence indicator. It’s been available to traders since at least the 1970s when Gerald Appel began writing about it. The indicator is most commonly viewed as a series of bars, like the ones shown below prices in the chart below.
MACD is designed to identify changes in the direction of price momentum. The chart above shows when momentum is rising or falling and it also shows whether momentum is above or below zero, in other words whether it’s bullish or bearish while showing degrees of bullishness or bearishness.
To find MACD, the calculation begins with two moving averages (MAs). Usually, the 12 period MA and 26 period MA will be used. Other time periods can be used and the calculations can be done with weekly or monthly data in addition to daily data.
The two MAs are calculated and then the value of the longer MA (the 26 day in this example) is subtracted from the shorter MA (the 12 day in this case). Instead of using a simple moving average, traders generally use exponential MAs to find MACD.
An exponential moving average, or EMA, is often thought as being more responsive to the market action than a simple MA. This means the EMA will be closer to the most recent price than a simple MA and should give signals faster.
The formula for MACD is:
MACD = 12 day EMA – 26 day EMA
But, that’s not what is shown in the chart below. MACD is nearly always shown with a signal line, which is a 9 day EMA of the MACD line. The bars in the chart above are found by subtracting the value of the signal line from the MACD.
In the monthly chart, MACD is negative, indicating the trend could reverse. This is just the sixth time since 2006 that this has happened. It takes a significant amount of data to calculate the indicator and that is why the indicator begins near the middle of the chart.
The chart shows monthly sell signals are reliable and if a trader followed just one momentum indicator, the monthly MACD could be the most valuable.
Right now, MACD is warning of a decline, confirming the signal from stochastics.
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