Back to the bull, or still a bear? | The Mesh Report

Back to the bull, or still a bear?

Christian Tharp, CMT July 14, 2010 0

A couple of weeks ago I wrote a newsletter making the case for the start of the renewed bear market. Take a look at the chart below and I think you will get the point of that newsletter. You will notice an important notation in red, which is a key break of support.

S&P 500 – 1 YR

The break of that support, combined with all of the headlines and the obvious lower-lows & lower-highs of the past 3 months seemed to paint a clear picture. But as you may already know, the market is very seldom “clear”.

Flash forward to now, and as of today, the market has completed a 6-day rally culminating in an 8% gain for the S&P. So, the question on a lot of investors’ minds is: Is the worst over or is there more to come?

Although only history will answer that question, a lot of times we can get a sense of what may be to come by analyzing the chart the market itself. Please take a look at the chart of the S&P I have shown below. You will notice that I’ve added the 50-day SMA (simple moving average), a 200-day SMA and the support level from the chart I have shown above.

S&P – 2 YR (3/2007 – 3/2009)

For anyone who is not familiar with a SMA, it is simply a line that plots the average price of a security for the last 50 days. As the current daily price is added to the average, the 51st day past is dropped. So, as the price of a security drops or rises, the SMA will rise or fall accordingly. The same process can be applied to the 200 day time period, as I have done above. As you can see, the shorter time period of the SMA, the quicker the average adjusts. Moving averages can help to smooth out a trend, but they can also commonly be used as trading “signals”.

A very common long term trading signal is when the 50-day SMA crosses above or below the 200 day SMA. When it crosses above, it can tend to be a good indicator of an upturn in the markets and vice versa for when the 50-day crosses below the 200 day SMA. You will obviously notice in the chart above that the 50-day SMA had recently crossed BELOW the 200-day SMA, signaling a potential change in trend. Of course, that expected change in trend would be from up to down. For an example of the last occurrence of a 50/200 “crossover” (or “cross-under” depending on your terminology) for the S&P, please look at the chart below:

S&P – 2 YR

You will notice that the last time we had a 50/200 crossover on the S&P was at the beginning of our current rally. The 50-day SMA crossed back ABOVE the 200 day SMA signaling the trend was changing. If you look at the next chart, you will see the previous time in which the 50-day SMA crossed BELOW the 200-day SMA:

S&P – 5 YR – 2004 to 2008

The last time the 50-day SMA crossed below the 200-day SMA, well, we all know how that turned out. However, there may be a glimmer of hope to this current downtrend. In the above chart I have outlined (2) “fake-outs” that occurred during that bull market. In both of those instances, the 50-day SMA did cross under the 200-day SMA briefly, but quickly rose back above it within a couple of weeks. If you are looking for a confirmation of a renewed uptrend, the 50-day SMA would need to get back above the 200-day soon. If we continue to fall lower, the any idea of a fake-out could be extinguished. Want to see the previous (2) 50/200 crossovers and how they turned out?

S&P – 5 YR – 1999 to 2004

As you can see, the last (2) 50/200 crossovers were also very reliable signals of trend change in the market. The 50/200 crossover in 2003 started one of the longest bull markets in history and the one in late 2000 was the start of the preceding bear market.

The previous (2) charts also show another common occurrence, which is that it is not uncommon for the 200-day SMA to act as either support or resistance for the 50-day SMA. Just something to keep in mind for future reference when using these particular moving averages.

So, the markets are rallying higher and if they can continue their run, could this recent 50/200 crossover just be another “fake-out”? Well, there’s one little hurdle standing in the way. If you look at the next chart, you will see that there is significant resistance standing in the market’s way:

S&P –

Just like the moving averages can act as support or resistance for each other, they can also act as support or resistance for the market itself. You can see how either the 50-day or 200-day SMA has acted a resistance for the S&P for the last 2 months and before that they tended to act as support for the market. Now that we are approaching BOTH the 50-day and the 200-day SMA, will this stop the market in its tracks?

The Tale of the Tape: The S&P is fast approaching both the 50 and the 200-day SMA. Both of these averages can be expected to act as resistance for the S&P. The 50-day SMA has crossed below the 200-day SMA, which tends to signal a downtrend in the overall market. Unless the S&P can manage to break above both averages, and quickly bring the 50-day SMA back above the 200-day SMA in the process, the trend should remain down for quite some time. If this ends up being the case, the highest probability trades will be on the short side. Just remember, the trend is your friend.

No matter what your strategy or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade.

Good luck!
Christian Tharp, CMT

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