Red Flags Waving for Stock Market Bulls

Friday's break of the 80-week moving average raises the stakes for stocks this week

by Todd Salamone

Published on Nov 26, 2018 at 8:52 AM

"I like to keep unpopular but significant moving averages on my radar… One moving average that I have used is the 80-week moving average… It is off the radar of many, if not most, market participants. However, it has had an uncanny knack for signaling poor future price action on breakdowns, while also marking support during various market drawdowns."
-- Monday Morning Outlook, October 29, 2018

"The jury is still out as to whether the current action precedes another serious leg down or a continuation of the longer-term uptrend. But it does follow the script that I described late last month when pointing out that past breaks below the 200-day moving average do not have a good track record of foreshadowing long-term bearish price action. However, short-term volatile, choppy action like we are seeing now tends to be an immediate byproduct of such breakdowns."
-- Monday Morning Outlook, November 19, 2018

It was a dismal week for bulls in an abbreviated Thanksgiving week. For example, the Nasdaq Composite (IXIC - 6,938.98) fell below its October low, with Tuesday’s close 15% below its late-August closing high. However, it found support around its February lows. 

Moreover, the Russell 2000 Index (RUT - 1,488.68) and S&P 500 Index (SPX - 2,632.56) declined again, retesting their October lows in what bulls are hoping could be a double-bottom. Both indexes dipped into the red once again for the year, with the SPX closing below support at the 2,650 half-century mark. The jury is still out as to whether equities are carving out a bottom or if there is more selling to come.   

On one hand, the technical backdrop is worse now than earlier in the year, when the SPX declined 10% but never broke below its 200-day moving average. Since breaking below this popular long-term trendline in mid-October, the SPX has been mired in volatile and choppy action, with highs in the 2,800 area and lows around 2,650 -- from which the index bounced early in Wednesday’s session, before giving way to lousy afternoon action and additional weakness on Friday.

The SPX closed below its 80-week moving average on Friday, currently situated at 2,660. As I mentioned late last month, this long-term trendline has served as a major pivot point after periods of short-term weakness, but tests of this level can foreshadow intermediate-term to longer-term sideways action at best -- or months of bear-market action at worst, on breaks below it. Unless the SPX immediately recovers from this technical breakdown before the end of the month, risks have grown substantially for weakness over the next few months, or even a transition into a bear-market environment.

Since 1980, breaks of the 80-week moving average have usually preceded tests of the 160-week moving average, which approximates a roughly three-year moving average. With the 160-week moving average currently situated around 2,400, bulls run the risk of at least another 10% pullback if there is a significant breach of the 80-week moving average on a weekly closing basis. A break of the 160-week moving average would likely foreshadow further bear-market action. The two graphs below give you a visual with respect to the importance of the 80-week and 160-week moving averages since 1980.

If last week’s SPX dip below its 80-week moving average proves only temporary, a bounce from this longer-term trendline -- which is just above a half-century mark on the SPX -- must be confirmed by a move above the round 2,800 century mark and the Nov. 8 Federal Open Market Committee (FOMC) meeting day closing level of 2,806. If the SPX fails to take over these levels on an advance, rallies should be viewed as simply bounces in the context of longer-term weakness.

SPX weekly MMO 1

SPX weekly MMO 2

A potential red flag for bulls is the market not responding favorably to triggers that, in recent months, have been bullish. For example, while the market has displayed weakness in the immediate aftermath of a Fed rate hike since December 2015, it has shown minimal drawdown at worst, and impressive strength at best, after Fed decisions to hold rates steady, as it did on Nov. 8. Typically, bullish price action has followed when sentiment among market participants was negative ahead of decisions to hold rates steady, which was the case earlier in the month. However, significant downside has occurred since the FOMC decision. 

"Disappointing data and earnings updates could ignite periodic panics over the threat of recession, even if remote. Markets are likely to be much choppier that than they’ve been in recent years. Gains could be lower. In other words, the market may be messy for a while"
-- New York Times, November 20, 2018

"Cash Will Be King Again as the Stock Market Slides, According to Goldman Sachs"
-- Barron's, November 20, 2018

"I think we’re in an environment where we’re going to have low returns going forward for a very, very long time."
-- Ray Dalio interview with Bloomberg, November 19, 2018

"Tech stocks lead market plunge; is long rally over?”"
-- Los Angeles Times front-page headline, November 21, 2018 

I have been saying for the past few weeks that there is evidence of the kind of pessimism that is needed for the market to put in a bottom, and this is still true at present, as you can see in the various anecdotal excerpts above. But the breach of the SPX 80-week moving average in last week’s action means the contrarian significance of this pessimism runs the risk of being downgraded, as higher levels of negative sentiment will be expected if stocks continue the current course (see my comments on the put/call ratio below). 

In June 2012 and June 2016, the SPX experienced weekly closes below its 80-week moving average but recovered quickly, generating only a single data point below this trendline. The SPX will have to do the same if there is any hope for this heightened pessimism to unwind on the heels of the Fed’s decision to hold rates steady earlier this month.   

If you are looking for a repeat of the action that followed those brief 80-week moving average breaches in June 2012 and June 2016, use call options to reduce your dollar exposure to the market amid the increased risks that I discussed. Beware, however, that rallies may prove to be short-lived. If the SPX remains below its 80-week moving average, put options should be employed to take advantage of the growing possibility of weak price action in the weeks and months ahead.   

put-call ratio MMO

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