Trader’s Narrative

A while back I presented a historical study which looked at the behaviour of the S&P 500 relative to its long term trend line: what happens this far above the 200 day moving average? If you haven’t yet, go check it our for full details because what follows will make much more sense.

When the Dow broke 10,000 (for the nth time) in the middle of last month, I cautioned that stocks had risen into thin air (again). The S&P 500 meandered around 1090 for a few days and then fell back.

Now, once again, looking at the same technical metric, I would be remiss to not issue another cautionary note:

As of today’s close, the S&P 500 index is 18.6% above its 200 day moving average. That is very close the 20% ceiling that seems to exert an almost magical restraint on momentum.

In the days left in the week we could potentially move up to 1120, which would expand the distance between the close and the 200 day moving average to approximately 21%. That’s really the maximum distance that it has been able to roam away from its long term trend in the past. So that’s about +2% further gain in equities from where we are.

Also, remember that tops that form at the 20% ceiling tend to cluster. So just like mid October, we may see a few days where the S&P 500 hovers around the 1120 area before either dropping as it did before or simply plateauing (to wait for the long term average to catch up).

Although this message may appear bearish in tone, it is only in the short term. If my prediction is borne out, then the S&P 500 will have made yet another higher high (and higher low) - the very definition of an uptrend and a rather beautiful chart formation.

Finally, it seems that every time I write along these lines, someone comments to remind me that the “markets can do anything”. So allow me to nip that in the bud.

Well, yes, of course the market can do anything. I’m not under the illusion that I can restrain them or to make them do my bidding. I’m simply observing a pattern of behaviour that they have exhibited in the past and projecting from that a probability. So I hope that is crystal clear.

Everyone is excited that the Dow Jones Industrial is above 10,000 - again. While that nice round number may be where most of the attention is, there is another level which we’ve hit that is more significant.

But before I get to that, it is remarkable that every single major index has reached a new high. That includes the Russell 2000 and important sectors like the Philadelphia Bank index (BKX), Semiconductors (SOX) and even the Dow Jones Transportation index managed to reach a new higher close (while not exceeding the intra-day high on September 19th 2009). Also reaching a new yearly high is the Mid-Cap S&P 400 index as well as the Small Cap S&P 600 index. All in all, it would be accurate to say that a rising tide has lifted all boats.

But while everyone is partying like its 1999, excuse me for being a kill joy. The S&P 500 index has once again risen so far above its own 200 day moving average that it gives us reason to believe that all these new highs have stretched an already exhausted trend to the breaking point. Or at least to the resting point.

I presented a historical view of what happens when the S&P 500 is this far above its long term moving average. You can find the details in the previous link but the concise version is that this is not a good time to be long equities.

This rally was launched in early March 2009 when the S&P 500 was almost 37% below its long term moving average. Now it has reached 20% above it. Twice.

The first time in recent history was last month (September 16th) when it hit 20.27%. Not long after we had a very shallow and short lived pull back. And with today’s close it is 20.46% - once again above that magical 20% mark.

By the way, the S&P 500 managed to eke out a +2% advance in the 30 days that followed that first signal in mid September. That’s slightly better than the -1.16% historical average.

Since 1950 to now, we’ve seen very few times that the S&P 500 index has traded 20% above its long term moving average. In fact, the market usually tends to bounce between +20% and -20% like a ping pong ball. To see a large chart showing this, check the link above.

So what we are seeing is rather rare. And the consequence has been historically that the market will have to go sideways or correct. What it can not do is continue to sustain the pace it has so far:

The tendency for equities to remain within a +/-20% band of their long term trend persisted even during the birth of the super-bull market in late 1982. Then, the S&P 500 was barely able to nudge past the 20% mark, reaching a high of 23.28% above its 200 day moving average in early November 1982. While the index itself reached a high of 143 at that point, it was only by February 1983 that it was able to leave that level behind for good. So during one of the most powerful rallies, the S&P 500 basically tread water for 3 months. That is a persuasive precedent demonstrating the power of this simple indicator.

The other insight from this indicator is that at the top we tend to see a clustering of instances at or near +20%. This is indicative of the nature of market tops as they take much longer to form than bottoms. So far we’ve seen 3 instances of +20% during 30 days. We may see a few more. But the message provided by historical patterns is the same. At best we pause to allow the turtle-like 200 day moving average to catch up to the hare-like S&P 500. And at worst (for the longs) we correct sharply lower taking price down to meet the rising long term trend.

Either way, this is not exactly the time to pass around the party hats.

When you take a step back and get a very long term perspective on the stock market, you realize that an apt analogy is a dog pulling on its leash. There is an overarching trend - which is the path set by the owner - but like a distracted puppy, the market can pull in one direction for short, intense spikes.

By watching the relative distance to its moving average we can tell where we are and how probable it is that we revert back to the very long term trend. This is what I referred to when I built a case for being bullish in March 2009: Another Reason We’ve Seen the Market Low. To my shock and horror, on November 20th 2008 the S&P 500 closed almost 40% below its 200 day moving average. It had never done that in the entire history of the index!

And in keeping with every other similar spike down, 60 days later, the index had recovered. In fact, we saw the sharpest rally to match the never before seen spike low.

We’ve now come full circle and are at the other end of the extreme. Last week, the S&P 500 closed 20.27% above its 200 day moving average. To give you an idea of how rare this is, here’s a chart of the S&P 500 relative to its long term moving average from 1950 onwards (click to see the larger version open in a new window):

Not only have we never seen this measure sink so low, we’ve also never seen it recover so fast! It took only 206 trading days for the S&P 500 to go from being 39.79% below its 200 day moving average to being 20.27% above it. The only other time we saw a similarly quick lurch from the abyss to the heavens was when bell bottoms and butterfly collars were the rage.

Back then, it took the S&P 500 only 185 trading days to go from being 28.8% below its 200 day moving average (on October 3rd 1974) to being 21.6% above its moving average (on June 26th 1975). That tidbit may be fascinating to know but I’m sure you’re wondering, so what happens when we are this far above the 200 day moving average?

To answer that, I went through the daily S&P 500 data and marked the appropriate dates where we approached or crossed the 20% Maginot line. Since such instances tend to clump together, I only considered the first date and ignored the repeats during the same month.

So for example, on May 5th 1975, the S&P 500 traded at 90.08 which was 19.66% above its 200 day moving average. Then a few days later on May 9th it closed slightly higher relative to its long term moving average (20.10%). I ignored all such repeats. I then calculated the forward 1 month, 3 month and 6 month returns (excluding dividends) from the first date. Here are the results:
Continue reading ‘What Happens This Far Above The 200 Moving Average?’

With the benefit of hindsight, lets take a look at my bullish calls in March 2009. I’m sure that persevering readers will remember a few of them. For example, the suggestion that we were about to witness a ‘bear trap’ - similar to what we launched the super-bull market from August 1982.

I also showed a chart of the rolling 10 year returns for the Standard & Poor’s 500 index. So at any point, that chart shows what you would have gained over 10 years (ex-dividend) had you invested at that time.

For me the most interesting, from a technical analysis point of view, was a deceptively simple indicator: how far prices are from their simple 200 day moving average. In Another Reason We’ve Seen the Market Low I suggested that prices deviate from their long term trend, sometimes extremely but that eventually, they revert back and the cycle begins again. Here is the updated chart:

On March 9th 2009, the S&P 500 was stretched to the downside to an extreme degree that we had not seen in a long, long time. Although we can look at the difference between prices and the long term average as points, this isn’t helpful over time. So instead we normalize and express it as a percentage. So in early March, prices were below their long term trend by more than 36%!!

We’ve since recovered and are trading almost 12% above the 200 day moving average. Of course, the spring rally had already begun by the time I wrote about this market dynamic on March 31st 2009. To be exact, by that time, the S&P 500 index had already rallied 18%. But even then it wasn’t too late to jump aboard.

Looking ahead 60 days from the extreme posted in March 9th of -36.53% distance from the 200 day moving average, the Standard & Poor’s 500 index rallied a total of 39.65%. So the record since 1960 is:

• 7.95%
• 10.03%
• 12.93%
• 10.72%
• 6.14%
• 9.54%
• 8.3%
• 20.9%
• 39.65%

For an average 60 day return of 14%. The latest recovery is by far the largest in our time period lookup. No doubt due to the fact that we had two dates close together when prices were pushed lower in a panic: November 20th 2008 (-39.79%) and March 9th 2009 (-36.53%). The other precedent of this was in 2002 just as that bear market was breathing its last: July 23rd 2002 (-26.98%) and October 7th, 2002 (-23.84%).

A recent mention of cumulative TICK on Trader Feed blog caught my attention and I looked at this indicator today. Now I know, Dr. Steenbarger’s chart of cumulative TICK is using the NYSE TICK data and it is very short term in contrast to my analysis.

But he does briefly mention that “…the Cumulative NYSE TICK has stayed well above May levels.” And then goes on to extrapolate:

Continued strength in Cumulative TICK would suggest to me that we’re experiencing a correction in a bull market, not the start of a renewed bear.

I’m not so sure we can draw that conclusion. For reasons that I’ve outlined many times before, I prefer to use the internal breadth data from the Nasdaq. So here is a look at a few years worth of cumulative TICK for the Nasdaq:

If a higher high is a sign of a correction within a bull market, then by that account according to cumulative Nasdaq TICK we’ve never even entered a bear market!

Now I know this is the Nasdaq data but the NYSE chart doesn’t look all that different. Which reminds me of the uselessness of cumulative breadth numbers (advance decline) as any type of indicator - NYSE Breadth Is Strong: Why It Doesn’t Matter.

Instead of looking at TICK data cumulatively, I prefer to smooth it using a simple short term moving average:

Although it has come down from the extreme in April 2009, it isn’t anywhere close to the range that has historically coincided with market lows (or lasting market bottoms).