The following is a guest post by Charles H. Dow Award winner, Wayne Whaley (CTA) of Witter & Lester. If you would like to be privy to his daily market comments and model ratings via daily email, free of charge, email him at firstname.lastname@example.org with the subject title “ADD ME TO DAILY EMAIL”.
On Tuesday, June 15, the S&P 500 closed above its 200 day moving average (200DMA) for the first time since May 19. Although this is important in itself, even more significant is the manner in which it has held this level over the last five trading days.
I’ve noted frequently that the market tends to gravitate toward levels that generate trading activity, regardless of whether the level’s genesis was old trading highs/lows, moving averages, round numbers, Fibonacci numbers, heavy option open interest, etc. If enough people believe in a level, trade off of it or try to hide behind it, it will tend to act as a magnet. Cognizant of these congestion areas, the locals, as well as the brokers who trade their own account, have a vested interest in driving prices slightly above or below these support/resistance levels to force trade executions. You have probably heard this market phenomenon referred to as “taking out the stops”.
For example, a popular commodity trading strategy is to get in line with the direction of trading range breakouts. A trade that I like even more than a breakout trade is a “failed” breakout trade. If the market goes down through an old support line and then reverses and trades back through it, the market has flushed out the breakout trades on the downside and then will often leave the breakout traders scrambling to cover their positions by reversing and closing above the support level. I have seen this trade referred to as a springboard trade, hook, or bear/bull trap and it will often give the market pivot momentum.
So how does this apply to the current market?
It would take some research, but is easy to argue that the 200DMA is the most important moving average in terms of market support/resistance, at least as far as equities are concerned. Due largely to the fact that the moving average test out very well in comparison to other time frames, the 200DMA is used by many institutions as a trend following and risk management levels that forces adjustments in portfolios. We can, at a minimum, agree there is more than normal business to be done at the 200DMA.
A very prominent springboard trade off of the S&P 500’s 200DMA occurred as recently as June 2nd, when the market was coming off lows and the 200DMA was at 1105.59. That day, the S&P 500 index traded intra-day through the 200DMA to 1105.67 before pulling back and closing at 1102.82 for a potential intra-day springboard reversal. The S&P then proceeded to lose 4.27% over the next 4 days.
I was interested in quantifying the odds of the 200DMA holding onto an initial crossover so I scanned data from 1970 through 2009 (leaving 2010 for forward performance calculations) and found 95 occasions where the market had closed above the 200DMA for the first time in at least 10 trading sessions. Not surprisingly, I found that on this first day after finishing above the 200DMA, the S&P 500 was actually down the following day on 50 out of the 95 days as the market attempts to find out who is in charge, the breakout traders or the springboard traders.
The springboard reversal trade doesn’t always occur intra-day as it did on June 2nd and will on occasion take a day or two to materialize. Last week, I was particularly interested to see if we could hold the 200DMA level for a few days. On the two days after the initial June 15th crossover, we traded slightly below the 200DMA intra-day on both days before closing above it, a sign of strength as we were able to withstand the attempts at the springboard reversal. In fact, as of today, Monday (June 21st), we have now closed above the 200DMA five days in a row.
I reviewed the 95 crossover cases previously identified and screened them further for instances where, not only did the S&P 500 break the 200DMA, but then avoided the springboard reversal by closing above the evolving 200DMA for five consecutive days, as we have just done. This narrowed the sample space from 95 to 49 and measuring from the close of the fifth day after the crossover (where we are today), I found the S&P’s performance to be above normal over the next one month, up 40 out of 49 (81.6%) cases for an average gain of 2.85%. As a point of comparison, measuring from the aforementioned 95 cases on the first day that the market crosses the 200DMA, the S&P was 64-31 (67.4%) one month later for an average gain of 1.51%.
Summarizing the 200DMA springboard implications, it is not only important to cross the 200 DMA, but equally important to sustain it for a few days as we have done over the last week to avoid seeing it become a failed pattern. The 200DMA is currently 1110.72, with the index closing today at 1113.20.
There are other bullish factors in play at this time to support the positive aspects of the 200DMA study that should also be considered:
- There is the strong intermediate tape activity that we outlined on June 2 in our Confusion Index article.
- Much has been made of the weak May-June seasonal tendencies (Sell in May and Go Away), but the S&P has actually been up over the next month (June 21-July 21) in 18 of the last 30 years, as the market usually behaves well in the days leading up to the July 4 holiday weekend.
- On the fundamental side, although the NBER LEI has not been shown to be a great stock market timing tool, it is my opinion that when coming out of a recession, it is a positive for equities that the LEI has been up 13 out of the last 14 months with a very strong May showing, suggesting that second quarter earnings have the potential to again exceed expectations next month.
So in summary, it is this quant’s opinion that until we see otherwise, the ball is back in the Bull’s side of the court.
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