S&P 500 in Worst Condition in Half a Decade

First, let me start this post off by saying I am a big "reversion to mean" investor - or "rubber band" theory. Meaning, the further a stock, or index gets away from support the more nervous I get and the more I expect some "reversion to mean" or a correction back down. This is why I cut back on stocks making large moves. Now, a popular investment methodology since the late 90s is pure momentum investing - that is buy the stocks making the strongest moves, or new 52 week highs and sell to the next person down the pike. Buy high, sell higher. I can't criticize that because when it works, it works very well - and as long as there are a lot of people willing to engage in this game, it can work for a long time. I have been surprised over the years how much farther a stock can run from its support levels - much farther than I ever think possible - especially in sectors dominated by retail investors (home "gamers"). But I attribute it to the "sell to the greater fool" mentality of buying a stock at its peak and hope someone comes in tomorrow and takes it off your hands... i.e. small cap solar stocks some days are up 30% and more than enough people are willing to come in the next day and buy a stock up 30% a day earlier, with hopes it goes up the next day. Seems like online poker to me, but there are many different strategies that work in the market, and whatever works for you. So while I miss out on those 'opportunities' by not playing that game, I find other strategies to be more conservative (in terms of limiting downside) and hence why I like to buy strong stocks on pullbacks to support levels (20 day or 50 day moving averages in particular).

I think one lesson people in the market for a long time learn is that only half the battle is making money. The other half is limiting losses. And these strategies of buying stocks up 30% to sell to the greater fool seem fraught with opportunity to lose a lot of money very quickly, especially if one is not a very able and rapid trader. It works.... until it no longer works. And then it implodes a portfolio if one does not sell quickly.

I mentioned this 'reversion to mean' because I want to point out the 5 year chart on the S&P 500. The 200 day moving average (for those new to technical analysis, all a moving average is, is simply the average price over a period of times - calculated daily it can provide a trend line that many investors swear by or indeed trade solely on) for the S&P 500 is now about 1479. The index is over 100 points lower or a 6.7% spread. Within the context of the past half decade this is an extreme - in fact as the chart below shows (click on it to enlarge), this is the worst level we've seen Spring 2003.

Meaning we have not traded below the 200 day moving average to this degree in almost 5 years. Hence why my "call" for a near term bounce back of some fashion. Hopefully lasting for more than 10 hours. This would be a probable event, but not a guarantee. There are always outlier events, such as 1987. The problem with rubber band theory is it works a lot better when a stock is trading above a trend line... when a stock breaks below a trend line the drop can be precipitous. See any home builder or restaurant or retailer or most financials to see what I mean. But again, an index is different from an individual name as its an entire complex of industries, and stocks so it should behave more in line with theory - outside of pure emotional panic periods.

However, a more troubling pattern has developed which makes me quite bearish. This chart shows we have been on "easy street" for the better part of 4.5 years. If you've only been investing to that time - well you have had quite the golden era. To see the opposite of a golden era look at Spring 2001 through Winter 2002/2003. But looking at this 5 year chart if you draw a line connecting the peak bottoms in

1. August 2004
2. April 2005
3. October 2005
4. July 2006
5. August 2007

You can see a support pattern created by these 5 peak bottoms - this is a "floor" on the market. If you continue that line to "today" you can see we are now trading below where that imaginary line would be placed - that happened in the past week to 10 days. And it is not a harbinger of good things, from this viewpoint at least. If I saw this in a long term chart of an individual stock, I'd flee for the hills. So I have to say at this point this deserves a change in character for the market as a whole. While I've been bearish on the coming economy for a long time, here we finally have a major index confirming economic theory for the first time. So the "masses" are finally listening; keep in mind one of the 13 Outlier Predictions is a 20% drop from peak (Oct 9th) to a bottom; this would be takes us down roughly 320 S&P points from the 1576 peak. Meaning S&P 1250ish. That's just a random number pulled out of thin air (20%), but it certainly would not be atypical by historical standards and it portends more weakness in the future.

Now, this could reverse and perception could be changed quickly but on a go forward basis as long as the indexes trade below this major trend line we have to assume bad things for the market in the mid term (until the markets break back above this imaginary line). But again, this does not mean we can not have a snap back rally but at this point this pattern would indicate on these rallies we want to lighten up, build short exposure along with cash - especially as we scrape against this (now) resistance level.

This does not mean individual stocks cannot rally, or specific sectors cannot do well. But it will be more like taking on the persona of a trout. We are going to be swimming upstream against some raging currents. And gains appear to be much harder to obtain.

For those who don't use technical averages or believe it is just hocus pocus feel free to ignore this post. I just find it a useful supplemental tool, and ignoring it would be like a carpenter saying I don't need the hammer in my tool kit. 90% of my work is fundamental analysis (thinking through macro themes, finding sectors that can benefit, finding the best stocks within those sectors) but knowing that so many people either use technical analysis solely, or in large part, I think it is prudent to keep aware of what is going on, if for nothing else to see things as how they are seeing things. And for those who focus on technicals, this is a very bearish set up.