May 8th, 2010

The 200-DMA Is the Key

It’s hard to believe but it has only been 10 trading days when on Wednesday April, 28, the S&P Index closed at 1191 and I wrote a remarkably tame and soothing “Nothing Warrants Wholesale Liquidation …… Yet“.

In that piece, I assured you that the market’s action, up to then, was far from issuing an unequivocal “all-cash” alarm because, at that point, the Index’s moving averages were still generally favorably aligned. They were all arranged in bullish mode with the 50- above the 100- which was above the 200- and at the bottom was the 300-day moving average. Finally and perhaps most convincingly, the Index itself was still above them all.

But everything changed over the ensuing 10 trading days. The market and its Index swiftly penetrated what should have been supporting moving averages creating extensive damage. Most of the blame was attributed to the European Sovereign Debt mess, the Gulf oil spill, Congressional action on financial institution regulation and, as a coupe de grace, a breakdown of processes and procedures in electronic financial markets on Thursday (which still can’t be adequately explained). Compare the chart in that April 28th post with yesterday’s below:

What wasn’t clear 10 days ago was the correction’s speed. On the one hand, most failed to anticipate the decline in any way and suffered severe damage to their portfolios. As I outlined in my game plane, I liquidated as various dominoes fell but failed to act quickly enough, winding up at only a 35% cash position (I had hoped to be 50% if the market did drop as far as it did). On the other hand, the panic-style swiftness creates a perfect situation for a bounce of sorts.

Market history has many precedents that offer some perspective on what to look forward to and what further actions to take. The key unlocking this view is the fact that the Index twice crossed the 200-day moving average on an intra-day basis. If Monday again turns into a liquidation day, then the Index will likely close below the 200-DMA, not an insignificant event.

The 200-day moving average is a crucial milestone for both individual and institutional market timers. As the market was bottoming in 2009, the Index crossed above the 200-DMA in July providing a highly anticipated signal that the recovery was solid and reliable. The Index crossing below its 200-DMA at the end of 2007, likewise signaled that a significant decline was immanent.

If it actually happens, the cross under will still be an unreliable bear market indicator because it will occur when the moving averages are still arrayed in a bullish alignment. When the Index has similarly crossed under the 200-DMA in the past, it stayed below anywhere from a day to at most 10 trading days (in fact there have been 81 of these “cross unders” since 1963). All but one was followed by the Index moving back above the 200-day moving average. For how long and for how much? That’s where the unpredictability comes in.

The bottom line is that there’s a high probability that those who missed out on the opportunity to become more risk averse by selling stock and increasing cash will have a second chance soon. Some will describe the move up as the end of the correction and the time to again buy stocks that have been marked down significantly. For the time being, I’m going to take a more conservative tack and look at it as an opportunity that passed me by.

The Bull has been injured and his forward momentum has been damaged. It will take time to either heal and resume it’s climb (which I not only hope but currently anticipate will happen during the summer in line with the mid-term election market pattern) or be mauled by the Bear whose momentum will pull the market further down. Right now, we just can’t tell which way it will go.

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  • Anonymous

    GURU,,can you advise if you are a Bull or Bear for Emerging Markets Bonds after the EU and IMF bailout ?Thanks for any info.Also please advise your views on China stocks this yr ?

  • Joe

    With the world financial situation so volatile and uncertain, it would be very irresponsible for anyone to make any longer-term forecasts concerning emerging markets, European markets or China. I'm having a hard enough time trying to get a fix on our own situation. That's why I'm in the camp that says the individual investor take money off the table.

  • Anonymous

    Great article Joe…

    I'm still thinking the market is in crash mode for the next couple of weeks. Then, re-enter bullish positions in early June.

    Tomorrow's peak should be a great opp to enter bearish positions and hold for a couple weeks. But I want to ensure that I have cash ready after the trade settles for the early June reversal.