The S&P 500 index lost the support of its long term moving average on May 20th. Many technical traders watch this level and react to it, making it a critical pivot. But does losing the 200 day moving average, forebode dark times ahead for the stock market?
We know from historical studies that the 200 day moving average is your friend. But keep in mind that its slope is still trending up. And we haven’t had the 50 day moving average fall down below it in a “Death Cross”. To me, those would be very ominous developments.
Taking a relatively long term look at the movements of the S&P 500 index in relation to its long term moving average shows that it has been here before and that within the confines of an uptrend (a cyclical bull market) this has indicated a buying opportunity.
It is only during severe bear markets that we see price crash well below its 200 day moving average. If you’ve just found the blog, you probably weren’t around when I used this same metric to point out the eye-popping extreme oversold: Another reason we’ve seen the market low.
Last week’s PBS Market Monitor interviewed Bernie Schaeffer of Schaeffer’s Investment Research and he discussed this topic at length:
Now the S&P, for example, has dipped below its 200-day moving average. That is a red flag for a lot of technicians and a lot of technicians will actually act on that signal and get out of the market. We did a study that had some interesting results. Since 1972, when you’ve been in a sustained uptrend, like we had been believe it or not before May, if you’ve been above the 200-day moving average for six months in a row or longer and you get this kind of a pullback, you actually see some significant out performance in the subsequent months.
So three to six months out, for example - you get - six months out, you get 8% plus gain in the S&P. Three months out you get 4% plus gain in the S&P, more than double what the market normally does over periods like that. So scary pullbacks in the context of a bull market are often buying opportunities if you can just take a deep breath and buy. I will suggest though there was one point in the past, in 1987, October, we all know that month, where that particular indicator didn’t work. So you want to be long, but you want to look for hedges as well.
Now having said that, we haven’t been this far below the 200 day moving average for a while. The last time was about a year ago in late May 2009. But back then, the 200 day moving average was falling precipitously and price was rising. That’s not what is happening now.
A more analogous time is late 2007 when the long term average was still trending higher and price was breaking under it after having successfully ricocheted off it several times in the previous years. Here is a zoomed in chart showing the recent price action:
As well, keep in mind that we are seeing considerable deterioration in technical metrics like the percentage of stocks above their 150 day moving average. After yesterday’s weak close, that measure closed at 27% - the lowest since early April 2009. The key distinction, and one that Schaeffer reiterates, is whether we are still in an intermediate uptrend or whether the trend has changed. Based on this breadth indicator, it is difficult to argue that the market still has the wind at its back.
But then, as I mentioned yesterday, breadth according to the cumulative advance decline line of the S&P 500 index is still surprisingly robust and exhibiting a rather sizeable positive divergence.
Finally, if you haven’t already, you should read the report from Dick Arms about the spike in the Arms index to 13.22 - his conclusion, not surprisingly is that we are extremely oversold and due for an imminent rally:
In summary, the current selling is very overdone. The broader market is in a sideways move, having broken down from the uptrend that lasted over a year. We are back down to the support of the sideways area in the market. Breaking that level decisively would put us in a bear market, but I do not think that is likely, at least yet. The extremely high Arms Index on Friday has a history of calling turning points. It also puts the moving averages into extreme oversold positions. Volume is still heavy, which is to be expected on lows. Volatility is high. All these factors suggest an imminent rally.
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