Why the S&P's 200-Day Is Only Part of the Story

The following is a reprint of the market commentary from the November 2014 edition of The Option Advisor, published on October 23. For more information or to subscribe to The Option Advisor, click here.

The week of Oct. 13 was a wildly volatile one for stocks. Due to a combination of disappointing economic data, mixed corporate earnings, and fears about the spread of Ebola, the major equity indexes were hit with heavy selling pressure.

In fact, the dramatic market action that week resulted in the highest total number of selling climaxes since Sept. 29, 2011. (A "selling climax" occurs when a stock hits a new 52-week low, but then settles above the previous week's close.) As indicated on the chart below, important market turning points in the recent past have often been accompanied by a huge spike in the total number of these types of climaxes. While it's obviously too soon to make the call -- there was a cluster of multiple selling climaxes in 2011, before the market eventually found its footing -- this could be a sign that we're in the process of capitulation.

With such dramatic volatility accompanied by a sharp sell-off, did we finally get the infamous 10% correction on the S&P 500 Index (SPX)? Not quite. Based on the index's 2014 intraday high of 2,019.26, and its Oct. 15 intraday low of 1,820.66, we registered a 9.8% pullback. Despite "failing" to reach this benchmark, the S&P did break below its 200-day moving average for the first time since November 2012.

Prior to breaching this widely followed trendline, the S&P had spent 477 consecutive trading days above it -- the third-longest such streak since 1950. As you might imagine, the index's drop below its closely watched 200-day sparked a ripple of panic among market watchers. This surging anxiety was reflected by a nearly three-year high in the CBOE Volatility Index (VIX), which occurred simultaneously with the S&P's 200-day break. (Anecdotally, StockTwits data shows that message volume for VIX spiked dramatically on Oct. 15 and 16, confirming a sudden flurry of interest in the market's "fear gauge.") So while the 200-day breach clearly triggered a wave of fear among investors, does this technical development necessarily suggest more pain and selling is ahead?

If history is any guide, the answer is most likely "no." Since 1950, there have been 13 other streaks similar to the one that just ended, where the S&P spent at least 252 trading days (approximately one year) above its 200-day moving average. The last three times a streak like this ended, the S&P proceeded to collect double-digit returns over the next 12-month period -- ranging from a 45.8% rally following the July 1996 trendline breach, to an 11.5% rise after the July 2004 break.

From a broader view, looking back at all 13 prior occasions when the S&P has breached its 200-day moving average after a long winning streak above it, the index has averaged a gain of nearly 12% over the next 12 months -- besting its average "anytime" one-year return of 8.8% since 1950. In other words, in circumstances in which the index has been firmly entrenched in upside action consistent with a bull market, that first break below the 200-day has typically represented a correction and a buying opportunity, rather than a sell signal.

However, for those traders who may have panicked out of their long positions following the S&P's break below its 200-day trendline, the market's quick and nimble reversal from its recent slump may have come as an unpleasant (and potentially costly) surprise.

On the other hand, if you'd also had the less-popular 320-day moving average -- a trendline we at Schaeffer's have favored for years -- on your trading radar, you would have spent Oct. 15 witnessing a very tidy S&P pullback to this level. While the index briefly dipped below its 320-day in intraday action, this trendline was never breached on a daily closing basis. This test of moving average support was followed in short order by an S&P rebound back above its 200-day, and the index has continued to recover impressively from that bout of wild mid-October volatility.

In light of these developments, it seems safe to affirm our belief that one indicator does not a trading system make. Despite the surge in fear that accompanied the S&P's most recent 200-day breach, the index's past performance suggests that this technical occurrence, when it follows on the heels of a long streak of outperformance, is rarely a reliable sell signal. By viewing day-to-day price swings within the context of longer-term trends, it's possible to keep your head while others around you are losing theirs. And it's worth reiterating that a roughly 10% pullback within the context of a years-long uptrend is, to a certain extent, inevitable -- as bull markets are quite unlikely to take the form of a straight vertical line (even though some of these 10% haircuts may transpire a little faster than the typical trader's constitution can comfortably endure).

Going forward, we recommend that you continue to watch the S&P's 320-day moving average as a key level of support, in order to keep the bigger-picture trend in perspective. And with earnings season, mixed economic data, and shifting monetary policy keeping traders on their toes, our Monday Morning Outlook column will help you stay current with the crucial technical levels we're watching each week.