August 11th, 2009

What’s Holding Back Sustained Market Growth?

They’re old, they’re classic, they’re simple …. but moving averages are excellent gauges for measuring momentum and trend. At one extreme coming from Southeast Asia and a frequent contributor to CNBC, Daryl Guppy uses the alignment of 10 moving averages (5 faster and 5 slower) in a trading system for forex and stocks. Others use simpler systems, like cross over and MACDs. Those familiar with this blog know that I fall in the middle using 4 moving averages simultaneously (50-, 100-, 200-, and 300-day MAs) to help me modulate my strategies.

The moving averages helped us from becoming overly optimistic during last March-May’s bounce and labeled it a suckers’ rally. In March, the distances between the Index and its trailing moving averages had become so vast that it contributed to a call of “market bottom”.

Because the market seems to have now completed a real base (the inverted head and shoulders reversal pattern), I went back to my data base to see how quickly the market will come out of this base formation and discovered something I hadn’t focused on before: how much effort will be required and how long it will take for the moving averages to confirm that there’s sufficient market sentiment to sustain a new bull market. In other words, the 300-day moving average, the slowest of the four moving averages, needs to finally turn and begin trending up.

I extrapolated several alternative trends and got a dose of reality, like having a bucket of ice water dumped on my head (for data and graphs, click here; note the spreadsheet has separate tabs for each growth assumption). Here are the summary stats:

It will be nearly impossible for the 300-day moving average to turn up and start trending higher, even marginally, before the end of the year under any of four alternative assumptions of growth in the S&P 500 Index. The S&P Index would have to grow by an average 8% each month from yesterday through New Year, ending the year with an unlikely close of 1531, or 51.6% above current levels, for the 300-day moving average to begin turning up by then. Any more likely slower growth rate (lower year-end close) finds the MA turning up only sometime in the First Quarter 2010.

Another benchmark measurement is the gap between the Index and its moving averages:

Under the aggressive 8% growth assumption (the growth rate required for the 300-DMA to turn up by year-end), we discover that the Index would be a whopping 52.3% above the moving average. What’s the likelihood of that happening? Not very. Since 1963, the biggest gap between the Index and its 300-DMA was 28.35% on May 6, 1983, almost half the gap that would result for the 300-DMA to turn up by year-end.

For those of you who weren’t in the market then or don’t remember it, the economy at the beginning of the 1980’s was at the tail end of what some today call the worst recession as far as prices and jobs are concerned, even worse than today’s. The market declines of January-March, 1980 and January 1981 – August 1982 resulted from the 1979 Iran-Iraq war, reduced oil supplies, high inflation, the Fed raising rates and ultimately reduced business spending.

But by Fall 1982, conditions had improved. The Dow Jones, after nearly 12 years of trying, successfully crossed above its 1000 milestone for the first time to great jubilation. The recession was ending, inflation was reduced (13.5% to 3.2%), interest rates declined from 21.5%, gold declined from a $875 peak and the Iran Hostage situation had ended with Reagan’s Inauguration. Here’s what the S&P looked like then:

Because the recession caused the market to decline “only” 24%, a rapid but modest recovery turned the 300-day moving average around. When the gap between the Index and its 300-DMA was at its widest, the MA was already trending up.

The situation, is dramatically different today. The 300-DMA hasn’t yet turned up and the 35% upside move already notched was merely to bring the Index back up to the moving average:

June 4, 2008, when the Index was at 1377.20, is the oldest date in the 300-day moving average calculation as of today. Before the MA can begin turning up, much of the devastation to the market in the second half of 2008 and the first quarter, 2009 would have to be purged or, at least, balanced out with higher more recent data.

Bob Prechter of Elliott Wave International is getting press for his most recent prediction that “the next wave down is going to be larger than what we’ve already experienced and take major averages well below their March 2009 lows….the late 2007-early 2009 market debacle was just a warm-up to what Prechter believes will be the bear market’s main attraction…..the current cycle will echo past post-bubble periods such as America in the 1930s and England in the 1720s, after the bursting of the South Sea bubble.”

I’m not sure I will go that far but while I believe that after the immediate “traders’ remorse” correction to the 950 area is completed, the next leg up beyond 1150 by year-end will be stunted by the need to rehabilitate market sentiment and fortify momentum as measured by the 300-DMA. That won’t begin until sometime early in 2010.

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  • Piazzi

    Guru,

    regarding your post titled "Traders' Remorse Correction: Wait it Out or Ride it Out?"

    I have never understood why many so much time on very complicated techniques and indicators, especially on shorter time frames, and ignore the power of a simple line connecting two pints (or more) on a lrager frame chart?

    when a trend is up, it is up, if I still have doubts, I buy insurance, but I should be in it

    regards,

    piazzi

    markettime.blogspot.com

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