On the 11th of December the US cut their federal funds rate once again, which marked the third rate cut in the past three months. Fed officials stated that “further cuts were possible if the severe housing downturn and mortgage lending crisis gets worse”. The rate cut disappointed the market, leading to a failed rally since its announcement.
The US Fed has now cut their interest rate by a half-point in September and a quarter-point in October. There was the hope that two reductions might be enough to combat the threat of a recession, given that financial markets appeared to be stabilizing. The continuing volatility through November and December and the rising fears of a US recession became the catalyst which led to the most recent Fed action in December.
Turning away from the fundamentals and back to the charts, what do they tell us? Which way will the market move next? What are the chances of a bear market evolving, or are we just in a volatile period that will pass? The question “are we evolving into a bear market” will only be answered after the fact, but there are technical definitions and observations that can assist us to determine the overall direction of the market and make trading decisions accordingly. The direction of the overall market (which I define as the “macro market view”) is critical to having the confidence for opening up a number of positions to take advantage of market direction. When the stock market rallies, 3 out of 4 stocks will move up with the Index. On the other hand, when the market sells off, 3 out of 4 stocks will decline with it. Knowing this, doesn’t it make sense to select trades in the direction of the major Indices? YES…
Looking at the S&P 500 chart above, the market is in a primary down trend. The recent Fed inspired rally failed, as the market broke below the swing low at X. Although the market is presently in a primary down trend, it is not by definition in a bear market. (More of that in a moment.) The market is in a period of unprecedented volatility, especially considering that we have had two 10% corrections, and this all started in August and continues through to the present. In addition, since the high in October the market has produced a series of quick falls and sharp counter trends, tracing out a series of lower lows and lower highs as the market fell. This type of price action was last seen at the top of the tech boom in 2000. I just want to repeat: this does not mean we are in a bear market. If not, what is the technical definition of a bear market?
A bear market can be defined using a 200 period SMA and a 50 period SMA plotted on a daily index chart. The definition of a bear market using these two moving averages plotted on a chart is the 50 period SMA trading below the 200 SMA and both pointing down. Do any of the major index charts show this set up? I went hunting and found this definition fits with one and only one index: the Russell 2000 index. The Russell 2000 is a market-value weighted index. The index measures the performance of the smallest 2,000 US companies. I wish to point out that none of the other major indices show this. Just in case the Russell 2000 turns out to be the “canary in the coal mine”, lets take a look at what potentially the other indices could evolve into if the market continues down.
Observing the chart we can clearly see that yes the 50 period MA is tracking below the 200 period MA. In addition we can see a series of lower highs and lower lows starting from the October high… To add to the picture the index is approaching its August low for a third test of this level. The more times an index tests a particular level, the greater the chance of breaking it. There can only be three scenarios that evolve. 1) The market quickly breaks through the August support level and continues lower. 2) The market will bounce off this support level retest and fall through, or 3) the August low turns out to be major support and this chart finds a bottom.
As previously stated “The direction of the overall market (which I define as the “macro market view”) is critical to having the confidence to opening up a number of positions to take advantage of the overall market direction”. If the primary trend is down, the majority of tradable positions shoud be short positions (puts etc). Although sharp counter trends are tradable and small positions can be taken, they become the riskier option because as these counter trend rallies fail, they do so very quickly.
We are not yet in a bear market that fits our technical definition. The strongest index has been the NASDAQ and the weakest the Russell 2000. As many traders will agree, the current market environment is unique in that it requires a greater level of discipline and definition of the primary trend, before a large number of positions can be opened.
Have a great Christmas everyone!
Kind Regards,
Paul Wise.