Trader’s Narrative

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%).

About a year ago I wrote about how the stock market resembles a dog on a leash. Prices fluctuate from the trend, sometimes in extreme spikes which mark important inflection points.

I thought I’d revisit the idea by taking a long term look at the S&P 500 and comparing how it has fared to its own long term (200 moving average). To equalize things and make it comparable over time, I expressed the divergence from the mean as a percentage:

Looking at the data from 1950 to present, here are the rare times when the S&P 500 Index (SPX) traded at an extreme relative to its simple 200 day moving average:

• July 26th 1962 -22.62%
• May 26th 1970 -23.18%
• October 4th 1974 -28.58%
• October 19th 1987 -24.75%
• Sept 21st 2001 -22.11%
• July 23rd 2002 -26.98%
• October 7th, 2002 -23.84%
• November 20th 2008 -39.79%
• March 9th 2009 -36.53%

The dates should be easily recognizable since they correspond to almost every single major turning point in recent market history. The numbers represent the percentage relative to the long term moving average. So on July 26th, 1962 the S&P 500 traded 22.62% below its simple 200 day moving average.

Looking at the data this way, you easily gain perspective on just how epic the recent market action has been. Not since 1929 has the market veered off so dramatically from its long term path. Put another way, if the November 2008 low doesn’t mark a significant inflection point, it will be the first time.

A quick back-of-the-envelope calculation shows that 60 trading days after these dates shown above the market is always higher, sometimes significantly:

• 7.95%
• 10.03%
• 12.93%
• 10.72%
• 6.14%
• 9.54%
• 8.3%
• 20.9%
• I’ll revisit this when 60 days have passed from March 9th, 2009

Even if we assume that the November lows will indeed mark a significant low for the S&P 500, there is no reason to believe that prices would simply climb higher from here onward. We could enter a protracted sideways market, or we could also slowly drip lower, revisiting the previous lows. But it is difficult to argue that what we have just witnessed isn’t but a monumental and rare market event that has characterized important turning points in the past.

You know how, when you’re walking a dog it pays no attention to the path or sidewalk and instead, driven by the instinct to collect and archive as many smells as possible, zig-zags to the left, then pulls to the right? It takes as much distance on the leash and as much of your patience as you allot it. Then you tug it back onto the path and the whole routine starts again.

Well, the market is a lot like that. A moving average being the leash and price being the dog. Here’s a chart of the S&P 500 relative to its 50 day moving average - I haven’t included an actual price index but I’m sure you’ll have no trouble matching the inflection points to important market tops and bottoms:

The above graph can be misinterpreted. So let me clarify: just because it peaks and turns down doesn’t mean that price has to. It may, or the average can rise/fall to close the gap and/or the S&P 500 can meander sideways.

A good example of such an exception would be October 2006 when the market, by this measure at least, got really extended. But even so it was able to grind higher, almost methodically, for another four months.

So to be clear, I’m not saying that the market is now definitely extended too much above its 50 day moving average. Potentially it still has room to go up. But at the moment, if it keeps up this pace, especially the tone set yesterday and this morning, it won’t take too long for it to get there.

Just something to tuck under your hat. And by the way, this doesn’t necessarily eliminate the long term bullish prospects for the market. This technical metric is useful in the medium term, which means that we can use it to watch for pauses or corrections within a much longer term bullish rally - similar to this other market breadth metric.