The Intermediate-Term Trend Is Not Your Friend
While the charts in this article look complex, the concepts illustrated are easy to understand and may be helpful in terms of gaining a better understanding of the stock market’s probabilistic outlook. From a portfolio management perspective, when the odds favor bullish outcomes, it is prudent to take more risk. When the odds favor bearish outcomes, increasing your cash position is a logical response.
Summary of the findings below:
- The stock market’s current intermediate-term outlook is bearish-to-neutral
- Potentially significant resistance for the S&P 500 sits between 1,300 and 1,315.
- Until we see improvement in the areas highlighted below, our bias should remain defensive.
- A break above 1,315 on the S&P 500 would greatly increase the odds for more favorable outcomes.
Moving averages help us smooth out trends or reduce the noise associated with the day to day volatility in the markets. We call the thin colored lines in the charts below a “moving average band”. The band is labeled on the left side of the chart below. The band contains moving averages for the S&P 500 ranging between 15 weeks and 30 weeks.
The moving averages break the current bull market into three basic phases. Phase A was the initial surge off the March 2009 lows. In phase A, the S&P 500 never closed below the moving average band on a weekly basis. The green arrows show where the moving average band acted as support. In phase B, the flash crash correction period, the S&P 500 never closed above the moving average band, which indicated a bearish bias. The red arrows show where the band acted as resistance. Notice the performance of the S&P 500 after the initial break back above the moving average band in September 2010 (early in phase C). The take away is when the S&P 500 is above or in the band, the odds favor bullish outcomes. When the S&P 500 is below the band, the odds favor a bearish period or period of sideways consolidation.
In the chart below, we have zoomed in to the transition from phase A (bullish) to phase B (bearish). In phase A, the slopes of the moving averages are positive, which tells us the general trend in the market is up. In early May 2010 (left side of phase B), the slopes of the moving averages started to roll over in a bearish manner – notice the performance of the S&P 500 after the bearish turn in the moving averages. The take away is when the slopes of the moving averages are positive (pointing up); the stock market has a bullish bias. Conversely, when the slopes of the moving averages are negative (pointing down), the stock market has a bearish bias.
If we apply the concepts illustrated above to the present day market, we see some troubling signs. In early May 2011, the moving averages temporarily acted as support (see the “stalled” notation in chart below). During the first week of June 2011, the S&P 500 broke below the band of moving averages, which told us the market’s bias had shifted in a negative manner. The more concerning development in the chart below is that the moving averages are in the process of rolling over in a bearish manner, or their slopes are shifting from pointing up to pointing down.
If the market can rally in the coming days, we would expect the moving average band to act as resistance just as it did on the first two rally attempts in 2010 (see red arrows in the 2nd chart). The current area of potential resistance is marked SR in the chart above. The tight cluster of the moving average band near SR tells us the resistance in that area may be quite strong. The levels where the resistance may come into play are between 1,300 and 1,315. The resistance near 1,315 makes any rally attempt somewhat difficult to participate in between 1,280 and 1,315 since the move may be short-lived.
If the S&P 500 can break above the top of the moving average bands (near 1,315), especially in a convincing manner, then our concerns would be alleviated a great deal. A convincing manner would include strong trading volume during the break and broad market breadth (percent of stocks advancing).
