November Option Advisor Commentary : A Tale of 3 Charts

              

The following is a reprint of the market commentary from the November edition of the Option Advisor, published on October 25. Prices and the chart are as of the close on October 25. For more information or to subscribe to the Option Advisor, click here.

This month, I'd like to examine the current technical condition of the S&P 500 Index (SPX) through the lens of two moving averages, and then compare this condition to that which existed ahead of the 1987 stock market crash and during the topping process for the Nasdaq bubble in 2000.

My moving averages of choice for this study are the 40-week and the 80-week. The 40-week moving average is functionally equivalent to the 200-day, and each of these moving averages are widely tracked as indicators of the health of a stock or market trend. If the 40-week moving average is rising and the asset is consistently trading above this trendline - implying that pullbacks are contained at the moving average - then the asset is generally accepted as being in a bull market. As readers of this space are no doubt aware, I prefer long-term moving averages as my lines of demarcation for market trends, for two reasons. First, they are less widely observed than the more traditional moving averages and thus have less potential to be devalued due to over-use. And second, their longer term nature tends to filter out some of the more random moves, so that penetrations of these moving averages can be said to have greater significance.

Looking at the accompany chart of the SPX from January 2005 to date, you'll note that there have been a number of penetrations of the 40-week moving average. But the 80-week held during the mid-2006 pullback as well as in August 2007. And while it is not shown on the chart, the pullbacks in the second and fourth quarter 2005 were also contained at the 80-week. Also, as a measure of the "frothiness" of the 2007 market, I note that the SPX peaked in July at about 13.5% above its 80-week moving average, and is currently 8% above this trendline.

Moving on to the chart of the pre-1987 action in the SPX, note that the peak in August 1987 was about 27% above the 80-week moving average. Also, there were no pullbacks in the two years preceding the crash that significantly penetrated the 40-week moving average. It was basically a two-step process into the crash - the 40-week was penetrated the week before and the 80-week during the week of the crash.

Our third chart shows the action around the Nasdaq (COMP) bubble peak, which I'll note occurred in March 2000 at a level 83% above the 80-week moving average. There were a number of post-peak penetrations and retests of the 40-week moving average as the bull market attempted to re-establish itself, but the death-knell came early in the fourth quarter of 2000 when the 80-week was broken and never retaken.

My conclusions from this study:

1. The current bull market is very much alive.

2. As measured by the frequent pullbacks to long-term support levels and the modest extent that rallies separate themselves from these support levels, this bull market is healthier than those of pre-1987 and Nasdaq pre-2000 and is considerably less vulnerable to crashes and "bubble pops." This is because selling is occurring on an ongoing basis, whether into rallies (which keeps a lid on the upside) or on the frequent pullbacks to support levels.

3. The major factor I see underlying the "containedness" of the current bull market and its consequent health is the huge growth since 2002 of assets in hedge funds and in other investment vehicles in which short selling and put option buying are staple strategies. A growing and ongoing "short trade" will cap rallies due to supply offered by short sellers and will support pullbacks due to short covering. The short selling and put buying constituency in 1987 and 2000 was minuscule in magnitude and extent compared to today, which "enabled" the excesses - first on the upside and then on the downside.