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Has Volatility Hit 'Lunatic' Levels?

The SPX has enjoyed a long-term relationship with support at its 80-week moving average

by 7/2/2012 10:22 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the July edition of the Option Advisor, published on June 21. Prices and the chart are as of the close on June 21. For more information or to subscribe to the Option Advisor, click here.

A widely quoted analyst of the gold and equities markets recently referred to the gyrations in the stock market as "lunatic," with the implication that it would be wise for investors to avoid serious market commitments under the circumstances.

In fact, I would suggest that the U.S. stock market has been behaving, both in terms of price and volatility, in a rather orderly manner in recent months, albeit one that has been frustrating to those of us of a bullish bent. And in making this case, I will refer to the accompanying weekly chart of the S&P 500 Index (SPX) along with its 80-week moving average and 14-week historical volatility.

Click to Enlarge

As you may be aware, the 80-week moving average is a longer-term construct I prefer in part because it is exactly twice the length of the most commonly examined moving average. Due to its greater length, it is by definition more stable. Due to this stability and the fact that it is not so commonly followed, it has the potential to provide us with much better guidance on the current long-term market trend and whether there is an elevated probability that this trend may reverse. And based on the historical price action of the S&P relative to its 80-week moving average as illustrated and discussed on the accompanying chart, it is pretty easy to conclude that this combination has provided us with guidance that has been of great value over the years.

Note, for example, the supportive nature of the 80-week moving average during the bull market of the second half of the 1990s as well as over the course of the 2003-2007 rally. In addition, breaks below the 80-week moving average (with subsequent unsuccessful retests) have, over the past decade, twice preceded major market declines, with a particularly impressive "one-two punch" occurring first in January 2008 when the 80-week was broken and then in May 2008 when it was unsuccessfully retested with precision after a sharp rally. More recently, the 80-week held in the aftermath of the 2010 "flash crash" sell-off, but it did not hold during the summer 2011 decline (though there was no huge market plunge in the aftermath). But the most recent market pullback (marked as point "A" on the chart) resulted in just a single weekly bar that closed below the S&P's 80-week moving average ahead of the subsequent bounce. So on the basis of this time-tested, trend-based indicator, the strong suggestion is we've thus far experienced a "normal" pullback in an uptrend as opposed to a trend reversal.

With regard to the volatility aspect of so-called "lunatic" market behavior, note from the "volatility" pane in the lower portion of this same chart that the 14-week historical volatility of the S&P peaked during the financial crisis at 74% (point "B" on the chart). And in the aftermath of last summer's Euro market crisis, 14-week S&P historical volatility peaked at 35% (point "C"). While in 2012 this volatility measure has been steadily rising from its low of 11% in March, it is currently just below 17% (point "D") -- less than half its peak of last summer and about one-fifth of its financial crisis peak. While there is something of a bearish case (to which I do not subscribe) to the effect that the market will not bottom until volatility at least approaches the aforementioned peaks, by no means of which I am aware can current market volatility be considered remotely extreme, much less "lunatic" in nature.

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