In my Money and Markets article a week ago, I came to the conclusion that while the S&P 500 Index doesn’t appear to be too expensive, stocks aren’t cheap either — a split decision.
Today I’m looking at another indicator to find out if the stock-market rally is justified: trend.
One of the simplest and most effective measures of the stock market’s trend is to watch prices relative to a moving average. Technical analysts use the 50-day moving average for intermediate-term trends and the 200-day moving average for long-term trends.
When prices are above both of those averages and the lines are sloping upward, it means the stock market is in an uptrend. You can see in the chart above that this is the case today.
For trend-following investors, it’s the picture of stock-market health. The 200-day moving average (red line) has been pointing higher for the past year. The short-term trend has been a bit choppy, with stocks selling off briefly below the 50-day moving average (blue line) on several occasions, but quickly recovering each time.
That reminds me of a Wall Street adage: “The trend is your friend … until the end when it bends!”
|Could the market’s trend be about ready to bend to the downside?|
In addition to the positive momentum of trends, stocks are also susceptible to mean reversion. Think of this as a pendulum on a grandfather clock. It swings only so far one way, and then swings back in the opposite direction.
Similarly, when stock prices reach an extreme above their moving averages, they tend to swing back toward the moving average — reverting to the mean — and sometimes fall below it. That is what triggers a stock-market correction, which is perfectly normal.
It has been a year now since the S&P 500 Index came even close to its 200-day moving average. Today, in fact, the benchmark index is almost 10 percent above the trend line.
You can see in the chart below that in the past, soon after this indicator reached such an extreme level, corrections have typically followed.
* In late 2009, the S&P 500 climbed to more than 20 percent above its 200-day moving average, and stocks corrected 16 percent into early 2010.
* The market climbed 15 percent above its long-term trend line in early 2011, and then stocks sold off nearly 20 percent.
* Again, in mid-2012, stocks rose about 12 percent above the 200-day moving average, and a correction of 10 percent soon followed.
So far this year, the S&P 500 hasn’t suffered a significant correction. The worst drop in stock prices came in June, when the index dropped 6 percent.
But at the beginning of this week, the S&P 500 was 8.6 percent above its 200-day moving average — and that’s getting extreme. Does that mean the market’s trend is about to bend to the downside?
A steep correction isn’t necessarily imminent just because the indicator is flashing caution right now. To the contrary, stocks can continue to rise further because, as we’ve seen, the S&P 500 can get 15 percent or even 20 percent above its long-term trend before correcting.
But this indicator does tell me stocks are probably overdue for a more significant pullback than we have seen so far in 2013.
Short-term declines are the market’s way of blowing off steam; they are a perfectly healthy part of any longer-term advance. But the longer we go without a correction, the greater the odds that when one finally arrives, it could be severe — in the 10 percent to 20 percent range.
Next week in Money and Markets, I’ll cover another indicator I use to help gauge the market’s next move: Sentiment. It’s a classic contrary indicator, meaning when sentiment is too sunny, markets are more likely to stumble. Spoiler alert: Stock-market bears look like an endangered species these days.