February 17th, 2011

The 12-mos. Oscillator Indicates There’s Room to Run

Barry Ritholtz has been pondering the duration and intensity of the rally in his Big Picture blog. My reading of the several posts on the subject leads me to conclude that he thinks the market could get dicey soon. As support, he inserted the following chart borrowed from TheChartStore that became a topic of conversation at tonight’s dinner table:

The chart says that, on a rolling 102 weeks basis, the last time the market’s rate of change has been this extreme was coming out of the Crash in the 1930’s. Furthermore, each time it hit this level, the rate of change then quickly plummeted back to a negative 102 week change.

The above chart is called an “oscillator”, a rolling measurement of the amount of change over a constant period of time. I started looking at a 12-month oscillator on October 23, 2009 in a piece entitled “More Evidence We’re Approaching a Top” when the market was 1079.60 and there were indications that the oscillator needed to decline before the market could advance further. In retrospect, that level actually marked the beginning of what became the interminable 14-month trading range that only ended with QE2 at the end of August.

I later updated the chart after Ritholtz posted on April 2, 2010 an item on the 12-Month Rate of Change in the Dow Jones Industrials (seems like items like these come out regularly annually). At that time, the message was “..going back 90 years, whenever, the 12 month rate of change has exceeded 40 percent, it has generally signaled trouble ahead…..Given those odds, increasingly exuberant bulls might want to have a rethink.”

Sure enough, the S&P 500 on that day was 1178.10 and, after a quick ascent to 1219 over the next three weeks, the market did retreat over the next two months to 1010.91 on July 1, a 14% correction. But that level was the low and two months later, on September 1, the current run began that’s carried the market 30% higher.

Since he’s back again using a different rate-of-change argument to alarm (warn, scare – take your pick) his readers, I went back and updated my 12-month oscillator:

My boundaries for the oscillator are 30% and -15% for the routine bull market and correction; boundaries of 40% and -25% indicate raging bull (bubble) and true bear (crash) markets . In other words, since 1940, these 12-month changes have contained most of the typical market trend swings.

Rather than conveniently picking an odd 102 week (approximately two years with 2 weeks for vacation, he says in jest) oscillator time period to make his case, I’ll stick with my consistent measure, the 12-month oscillator which, as of January’s close, indicates that the market is at the mid-point and, because of the year-long trading range that we’ve successful broken out of, there is still room to run on the upside.

As a matter of fact, if the market extends its growth at 1.6%/month reaching a close of 1531 at year-end, then the oscillator hits a high of 36.97 at the end of August when the Index would be at 1437 …. amazingly close to my current guess as to where we might see an intermediate correction. Because the market began to skyrocket last September, the market could continue its ascent at the 1.6% rate even as the oscillator begins to fall.