Thursday, December 20, 2007

Technical Thursdays: What a Decline to 1360 Means

In Tuesday’s blog posting, I provided a realistic worse case scenario for the S&P 500 – operating earnings for 2008 decline around 6% to $86 and longer term interest rates (10 year US Treasury) rise ½%. The combination of the two results in a decline in the S&P 500 to 1360, a level at which the potential return for large cap equities equals its historical long term average of 12%.

From a technical analysis perspective, what does it mean for the market to decline to 1360? Here are a few thoughts.

The above three charts* cover three distinct time frames that help shed some light on the characteristics of the current bull market current vis-à-vis the prior periods, one bull, one bear. In all cases, the application of the Moving Averages Principle (MAP) will be used.

Applying the moving averages principle to the first chart we see that the extended current bull market cycle (Jan. 1, 1995 to present) is in keeping with the global macro real economy trend of the Great Moderation. In three sustained cycles, the three components of MAP** are NEVER violated. Mega trends are sustained over several years with no whipsawing short term mega trend reversals. This, however, is not the case with the second chart.

Encompassing the period from August 1982 (the official start of the previous bullish supercycle) to Dec. 31, 1994, we see that there were three points at which MAP produced a mega trend reversal signal – Fall 1987, Fall 1990, and Spring 1994. In all three cases, the mega trend reasserted itself requiring investors to be flexible in their thinking and willing to reverse course as the bear signal produced was then reversed back to a bull signal. No doubt, there was some cost to the whipsaw nature of the times, selling when prices has already declined and buying back when they reverted to its prior bullish mega trend. However, that cost was miniscule compared to cost of missing the power of the reasserted bullish mega trend.

The third chart provides a view of much different time. Covering the time period of Jan. 1, 1970 right up to the start of the above noted bullish supercycle, the era of high volatility in the real economy (stagflation, extraordinarily high interest rates, etc.) was somewhat evident in the rocking and rolling of the market and the increased frequency of mega trend reversals – I count five – that took place, with a few additional very close calls.

Investment Strategy Implications

A break to 1360 will likely signal a change in the behavior of the market. A look back at the first chart shows that should such a break occur, not only will many market technicians (and no doubt numerous media mavens) point out that the prior lows have been violated (not to mention a more serious breach of the 200 day moving average) but, far more importantly, the MAP will signal a mega trend reversal.

For those adhering to the MAP, reducing their equity exposure will be required, despite whatever may be occurring in the real economy. However, as experience has shown, mega trend reversals can occur with greater frequency than many current bull market participants are accustomed to.

Should 1360 become a reality anytime soon, investors should be prepared for a period of whipsaw action in their asset allocation decision. This will then necessitate greater attention to the individual sectors and their mega trends. Moreover, a more thematic approach to investing might also be required to achieve alpha.

The bottom line conclusion is simply this: If 1360 occurs in the first half of 2008, the potential of a more permanent bearish trend cannot be ignored. Accordingly, investors should then reduce their overall US equity exposure. However, should a whipsaw occur (from bearish back to bullish), that will certainly cut into an investor’s performance results for the year, for the reversal signals tend to occur after a period of some decline or advance.

Net, net: Whipsaw action may be the new reality. However, the cost of ignoring the mega trend reversals is far too great compared to the cost of being whipsawed.

*click images to enlarge
**price relative to the moving averages, moving averages relative to each other, slope of both moving averages (50 and 200 day)
charts courtesy

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