From the Top

February Option Advisor Commentary

Examining the significance of the SPX's 40-month and 320-month moving averages

by 2/6/2012 9:31 AM
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The following is a reprint of the market commentary from the February edition of the Option Advisor, published on Jan 26. Prices and the chart are as of the close on Jan. 26. For more information or to subscribe to the Option Advisor, click here.

The accompanying monthly chart of the S&P 500 Index (SPX) since 1980 also displays 40-month and 320-month moving averages.

You might reasonably ask if we can glean any information of value about the health of the market and its upside potential from examining a 40-month moving average of the S&P, which encompasses more than three years of price action. Or, to push this envelope violently, is there any value to a 320-month moving average -- one of almost 27 years' duration? Or do such lengthy periods render moving averages so stale as to be irrelevant to the current environment?

Monthly Chart of SPX since January 1980 With 40-Month and 320-Month Moving Averages

The following excerpt from my article entitled "Trading on the Level" in the Summer 2011 issue of our SENTIMENT magazine discusses the effectiveness of longer-term moving averages as trading and timing tools:

"The 'standard issue' moving averages on a daily chart are the 50-day and 200-day moving averages. These are followed by just about every market technician and are frequently quoted in financial media articles discussing stock market action. As I discussed earlier, these are 'crowded' tools, and are best used as a reminder of what the crowd is looking at and not as tradable indicators. The crowded equivalent on the weekly chart of the 200-day moving average is the 40-week moving average... The advantage of creating moving averages longer than 40-weeks are two-fold -- they provide a smoother representation of price action (more signal and less noise) and they are on the radar of only a fraction of those who follow the standard issue variety and can thus be used as trading tools in addition to reference points."

Though 320 months is about 35 times the period encompassed by 40 weeks, let's take a look at the precision with which the S&P's 2008-2009 free-fall was contained at this multi-year level. The S&P's intra-month low in November 2008 at 741 was just 3% above its 320-month moving average at 717. In February 2009, the S&P's low (734) checked in at just 1.5% above the 320-month level (723). And at the absolute bottom of the market in March 2009, the S&P at its low of 666 was below its 320-month moving average reading of 725, but by month's end it had closed well above at 797 -- and the market's bear run, which had shaved almost 60% off the S&P from its October 2007 peak at 1,576, was over.

While the 320-month moving average of the S&P certainly defined a "level of interest" at this major market bottom, the 40-month moving average has been an effective tool at numerous other junctures. First, let's note the amazing fact that (other than for a period from mid-1981 to mid-1982) the S&P's 40-month moving average was not otherwise penetrated on a monthly closing basis from March 1979 to February 2001. Along the way, there were numerous tests and "close calls" -- including one during the infamous "crash" month of October 1987 -- but in the final analysis, the 40-month moving average defined the support levels time and again for a bull market over a span in excess of 20 years.

The break of the 40-month moving average in February 2001 was followed by a decline in the S&P of almost 40% over the next 20 months. But once the 40-month was re-taken on the rally in December 2003, the market never looked back at this level and ultimately rallied by over 40% into the October 2007 peak. And once again, the break of the 40-month moving average in June 2008 had very unhappy consequences -- this time, a 45% decline in less than a year.

But the good news for us right here and now is that the 40-month was re-taken in October 2010 and successfully re-tested over the course of August to October 2011. So is another big rally in the works -- perhaps of 40% or more -- that would take us beyond the all-time highs in 2007?

A strong clue may lie with yet another of the S&P's longer-term moving averages -- the 320-day. After languishing below this level for most of August to December 2011, the S&P re-took its 320-day moving average on December 29, 2011 and has not since looked back, thus far rallying by about 4%. When I combine the S&P's healthy relationship with its longer-term moving averages with what I see as a sentiment backdrop that's inordinately negative, the bullish case for the market becomes quite compelling indeed.

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