To quote from the first article in the Three Dragons series:-
"The Moving Average Theory (or the Three Dragon concept in our case), works based on a few assumptions. The first is that the market reacts fast. Whatever happens today will be reflected in the markets tomorrow. The second is that the market over-reacts, be it to good news or bad. It will either climb too high or drop too low, before regaining its senses and getting back on an even keel. The third is that markets, although random, moves in general directions for certain periods of time before changing direction. That is, it won't go sky high today and drop to an abyss tomorrow all the time. Great movements come once in a while, but generally, it tends to trend.
When combined, these factors mean that when we draw a moving average line to match the actual prices, we get a line that is less fluactuating, but trending in the same directions. The highs are lower and the lows are higher. Consequently, when the market gets ahead of itself and cuts the Moving Average line upwards, we can be fairly confident that the market's exuberance would push it further up. And when suddenly the market panics and begins a steep drop, the cutting of the Moving Average line a downwards motion would mean that it will likely be driven even lower. Remember, Green is more energetic than Grey or Purple and always has bigger motions.
The longer the period we use for the Moving Average, the less sensitive it will be. As sensitivity increases (shorter time periods), we would tend to be able to get in lower and get out higher, but this is offset by the many false starts.
This method is always a safety net, because it would get us out of the markets when it cuts back downwards, helping us to cut our losses."
Well, guess where the Green/Red Dragon is right now in relation to Purple Dragon:-
Yup, the FBM KLCI just touched its 26 week moving average in a downwards motion last Friday.
Is this an indicator that we should get out of equities for now?
A few points:-
~The lines have touched, but touching is not as decisive as cutting. Will the line cut through at the end of this week?
~The Green/Red line has touched the Purple line, but the Purple line is still far away from the Grey line. Again, the former is not as decisive as the latter.
~However, judging by what happened the last time Green/Red cut Purple, the aftermath was quite drastic.
A decisive cut below the Purple line at the end of this week may signal a general change in market trends?
To recap, the moving average (Purple Dragon) is like a magnet that will always, always, always, pull the KLCI (Green/Red Dragon) back to it. After Green/Red overshoots Purple in a certain direction, it will be pulled back the opposite direction and overshoot the new direction instead. Of course sometimes, Green/Red will touch Purple and then stay with it for a while. But irrational human greed (uptrend) and fear (downtrend) will often make it overshoot.
The full series of The Three Dragons; Tracking the FBM KLCI can be found HERE.









