If you believe stock market lore, the world’s most important stock index just avoided a bullet that has the power to kill bulls. But it’s a bullet that may exist more in the old war stories of traders than in market reality, technical analysts say.
The S&P 500 last week came perilously close to breaching its 200-day moving average – one of the most hallowed indicators of market strength for proponents of technical trading. Since then, however, the key U.S. stock market benchmark has bounced back, and advanced a further 1.3 per cent on Tuesday.
Some market watchers have taken this as evidence that the 200-day moving average - the midpoint of the index’s movements over the most recent couple of hundred trading days - has provided strong support for the market, and may have defined a bottom for the recent down trend.
Had the 200-day average collapsed – as it has in recent weeks for many of the world’s biggest stock indexes, including Canada’s S&P/TSX composite index – long-standing market wisdom holds that it would fuel a widespread selloff that could quickly turn into a full-fledged correction or, worse, the start of a new bear cycle.
“It’s been considered an important technical indicator for a long, long time,” said independent technical analyst Don Vialoux. “It’s considered a major way of determining whether a market is heading up or down.”
But history doesn’t support the notion. At best, analysts say, the 200-day moving average is a bearish signal for the stock market only under certain circumstances – and current conditions don’t fit the mould.
The Formula and the Myth
“It’s an ongoing myth,” said Jeffrey Y. Rubin, director of research at Birinyi Associates Inc., an independent U.S. market research firm. “If you’d followed the formula [of selling when the market fell below the 200-day average] you would have lost money.”
The S&P 500 has had 19 instances in the past 20 years when it has fallen below its 200-day moving average. In only two of those cases – September, 2000, and December, 2007 – did the move mark the beginning of a bear market (eventually falling 46 per cent and 55 per cent, respectively, from the breach of the 200-day average to the bottom).
The median decline from the breach of the average to the bottom of the declining phase was a mere 3 per cent – hardly indicative of a major sell signal.
Up or Down
The largest declines following a move below the 200-day average came in cases when that average was either in a clear downward trend, or was crossing over from an upward to a downward trend. When the 200-day average was trending upward – as it is now – a fall below the average was almost inconsequential: The median dip to the bottom of the selloff was just 2 per cent.
“What’s important is not whether we hold the 200-day moving average, but whether the 200-day moving average is moving upward or not,” said technical analyst Ron Meisels, president of Montreal-based independent research firm Phases & Cycles Inc.
Dennis Mark, technical analyst at National Bank Financial, said that when the 200-day moving average is trending upward, a dip below the average may still be considered “a warning,” but it “may not have an immediate negative impact.”
Analysts said it’s often better to look at the 200-day moving average in conjunction with the 50-day moving average, another key technical indicator. Mr. Vialoux said that when both are trending higher, and the 50-day is above the 200-day, it’s usually a bullish sign of market strength.
But this has deteriorated during the recent market decline. The 50-day moving average on both the S&P 500 and the S&P/TSX composite has turned downward in recent weeks, and the spread between the 50-day and the 200-day has narrowed dramatically – to the point where some market watchers are talking about a so-called “death cross,” a move of the 50-day average below the 200-day average. As the name would suggest, this is considered a highly bearish technical signal.
This, too, may be more myth than fact, Mr. Rubin said. “When you look at history, the market has actually done better after a death cross than after a golden cross [when the 50-day crosses above the 200-day]” he said.
Some analysts feel the 50- and 200-day moving averages are more meaningful for individual stocks than for indexes – and those may be sending a more positive signal.
Last week, only 13 per cent of the S&P/TSX composite index stocks were trading above their 50-day moving average – an exceptionally low level. Generally speaking, Mr. Vialoux said, any number below 20 per cent suggests “that the market is oversold, and due for a recovery.”
“It’s as low today as it was [at the bear-market bottom]in March, 2009, and [the correction of]July, 2010,” Mr. Meisels said. “These are not signs of panic, these are buy signals.”