As Dow Breaks 10,000 it May Not Yet Be Party Time

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Includes: DIA, QQQ, SPY
by: Babak

dow 10000 againEveryone is excited that the Dow Jones Industrial is above 10,000 - again. While that nice round number may be where most of the attention is, there is another level which we’ve hit that is more significant.

But before I get to that, it is remarkable that every single major index has reached a new high. That includes the Russell 2000 and important sectors like the Philadelphia Bank index (BKX), Semiconductors (SOX) and even the Dow Jones Transportation index managed to reach a new higher close (while not exceeding the intra-day high on September 19th 2009). Also reaching a new yearly high is the Mid-Cap S&P 400 index as well as the Small Cap S&P 600 index. All in all, it would be accurate to say that a rising tide has lifted all boats.

But while everyone is partying like its 1999, excuse me for being a kill joy. The S&P 500 index has once again risen so far above its own 200 day moving average that it gives us reason to believe that all these new highs have stretched an already exhausted trend to the breaking point. Or at least to the resting point.

I presented a historical view of what happens when the S&P 500 is this far above its long term moving average. You can find the details in the previous link but the concise version is that this is not a good time to be long equities.

This rally was launched in early March 2009 when the S&P 500 was almost 37% below its long term moving average. Now it has reached 20% above it. Twice.

The first time in recent history was last month (September 16th) when it hit 20.27%. Not long after we had a very shallow and short lived pull back. And with today’s close it is 20.46% - once again above that magical 20% mark.

By the way, the S&P 500 managed to eke out a +2% advance in the 30 days that followed that first signal in mid September. That’s slightly better than the -1.16% historical average.

Since 1950 to now, we’ve seen very few times that the S&P 500 index has traded 20% above its long term moving average. In fact, the market usually tends to bounce between +20% and -20% like a ping pong ball. To see a large chart showing this, check the link above.

So what we are seeing is rather rare. And the consequence has been historically that the market will have to go sideways or correct. What it can not do is continue to sustain the pace it has so far:

SP500 relative to 200 MA Oct 2009 topping

The tendency for equities to remain within a +/-20% band of their long term trend persisted even during the birth of the super-bull market in late 1982. Then, the S&P 500 was barely able to nudge past the 20% mark, reaching a high of 23.28% above its 200 day moving average in early November 1982. While the index itself reached a high of 143 at that point, it was only by February 1983 that it was able to leave that level behind for good. So during one of the most powerful rallies, the S&P 500 basically tread water for 3 months. That is a persuasive precedent demonstrating the power of this simple indicator.

The other insight from this indicator is that at the top we tend to see a clustering of instances at or near +20%. This is indicative of the nature of market tops as they take much longer to form than bottoms. So far we’ve seen 3 instances of +20% during 30 days. We may see a few more. But the message provided by historical patterns is the same. At best we pause to allow the turtle-like 200 day moving average to catch up to the hare-like S&P 500. And at worst (for the longs) we correct sharply lower taking price down to meet the rising long term trend.

Either way, this is not exactly the time to pass around the party hats.