This week the major indices shook off a sharp down day on Tuesday and by today had surged to an all-time high for the Dow and a new multi-year high for the Nasdaq. Today’s advance was largely supported by better than expected June sales by WalMart. Many investors and professional money managers are starting to express concern about the the continued staying power of this bull market run. But economic fundamentals remain strong so there is no reason to anticipate an immanent market downturn.

Right now most technical indicators remain positive, which isn’t surprising since virtually all technical indicators lag the market. In other words, most technical tools used by market analysts are not predictive. In fact, it is somewhat amusing to watch money managers create varying combinations of lagging indicators in the hope that somehow the right combination will generate a signal that becomes predictive.

One of the common mistakes most analysts make is that they fail to understand the limitations of the tools they use. A pipe wrench is heavy like a hammer, but it would not work well for someone framing a house.

One of the tools I commonly watch is a Moving Average Convergence Divergence (MACD). Created by Gerald Appel in the 1960s, it shows the difference between a fast and a slow exponential moving average of closing prices. The standard periods recommended back in the 1960s by Appel are 12 and 26 days:

    MACD = EMA[12] of price - EMA[26] of price

A signal line is then added by smoothing this with a further EMA. The standard period for this is nine days:

    Signal = EMA[9] of MACD

The difference between the MACD and the signal line is often shown as a solid block histogram. You can see this displayed on the chart below. The top portion is simply a daily price chart of the Nasdaq over the past year. The bottom portion is the MACD. The blue line is the 26-day EMA minus the 12-day EMA. The brown line is the 9-day EMA signal. The divergence between the two is shown as the black portion on either side of the zero mark.

Here is how Wikopedia describes this tool:  “The MACD is a filtered measure of the velocity. The velocity has been passed through two first order linear low pass filters. The ’signal line’ is that resulting velocity, filtered again. The difference between those two, the histogram, is a measure of the acceleration, with all three filters applied. The ‘MACD crossing the signal line’ suggests that the direction of the acceleration is changing. ‘MACD line crossing zero’ suggests that the average velocity is changing direction.”

Like many tools, the MACD fell out of favor when the tech bubble burst in 2000. Analysts that relied on this tool for a trading signal lost money in the correction, just like everyone else. Others who have relied on this tool for trading signals have learned that it is subject to whipsaws, just like almost every other technical indicator.

The real purpose and value of the MACD is to identify changes in trend. In that capacity, it is best used in conjunction with other tools such as Relative Strength Index, Advance/Decline Lines, stochastics, etc.

Notice on the chart above that right now, the MACD is not signaling an impending trend change. In fact, it appears to show that the Nasdaq could advance higher from this level. The MACD was at this same level in September 2006 and the Nasdaq followed with three months of significant gains. That doesn’t mean the same thing will happen this time. After all, we just acknowledged that this is not a predictive indicator. But used in combination with other technical and fundamental indicators we get a picture of a market that is still healthy.

Have a great weekend.
F.S.