Markets Have No Color, Stocks Don't Rhyme

by: Eric Parnell, CFA


We live in a time when stocks are trading near all-time highs, but many investors are still feeling insecure.

The scars of the tech bubble and the financial crisis have many worried that they could simply look away and the gains of the latest bull market could be gone.

Adding color to today's stock market can provide a sense of security that is reassuring during periods of increased volatility.

This article is the latest in the Market Sounds Of Summer series on Seeking Alpha.

Now you are here today,

But easily you might just slip away.

'Cause we live in a time,

When paintings have no color, words don't rhyme.”

- Sentimental Lady, Fleetwood Mac, 1972

U.S. stocks continue to hover near all-time highs. Sure, the S&P 500 Index remains more than -5% below its all-time highs notched in January 2018, but the NASDAQ Composite and small cap Russell 2000 Index were trading at fresh new peaks as recently as last Wednesday before this latest bout of volatility. Overall, the U.S. stock bull market remains ongoing as we continue through 2018 and overall sentiment behind stocks remains strong.

Yet concerns remain that the lovely stock market lady might easily slip away. Scarred by the devastating past experiences of the bursting of the tech bubble and the financial crisis over the past two decades, many investors remain braced for a major potential downside event erupting at any time. Not only is this particularly true today with amid a near record-long economic expansion and bull market, but the volatility that suddenly exploded earlier in the year was just the latest reminder of how quickly the U.S. stock market can become completely unsettled.

Stocks don’t rhyme today. Another issue that has dogged many investors throughout the post-crisis period is the fact that U.S. stock price performance has never really rhymed with the health of the underlying U.S. economy. Stocks have been awesome, but the economy otherwise lackluster. And this has resulted in a condition where stocks have been trading at historically high valuations for some time now even after the major tax cuts from late last year. Knowing that stocks are most at risk at premium valuations, many investors recognize the potential downside if companies are unable to meet now lofty profit expectations over the next few quarters.

Markets have no color. This leaves some investors in an uncomfortable position. They want to continue to have exposure to the U.S. stock market, but they also do not want to be caught up in the tumult when the bull market finally comes to an end and starts falling sustainably to the downside. And when markets have no color, it seems impossible to know exactly when the next move to the downside on the S&P 500 Index is going to be just the beginning of something much bigger.

The value of adding color to markets. Fortunately, a simple set of indicators is available that investors can use to establish a much better understanding of when today’s bull market is likely to come to an end and when the next major bear market is getting underway.

The following chart includes two key indicators. The first is the 200-day moving average (the average of the most recent closing prices on the S&P 500 Index through today), which is shown in red and is a representation of the long-term trend. The second is the 400-day moving average, which is shown in pink and is a representation of the ultra-long term trend.

The chart above leads to the first key takeaway.

1. The U.S. bull market is very much intact. But how can we say this when the S&P 500 Index is still -5% below its January peak and is taking a beating on Monday to start the new week? For the following simple reasons. First, the S&P 500 Index continues to trade above its 200-day and 400-day moving averages. Also, both the 200-day and 400-day moving averages remain upward sloping. If anything, what the chart above demonstrates is that the S&P 500 Index had gotten way too far ahead of itself by late January, and the weakness and volatility we have seen in the months since is nothing more than the U.S. stock market working its way back toward trend. Such is what is being described by a “healthy correction.”

According to the chart above, we could see the S&P 500 Index continue to fall all the way back to 2664, and it would be a perfectly normal downside pullback in the context of the ongoing bull market.

But what if the stock market continues to the downside? What if the S&P 500 Index ends up breaking below its 200-day moving average? This is where the second key takeaway comes into play.

2. The 400-day moving average is the next line of bull market defense. Often when stocks break below the 200-day moving average, they will find support at or near the 400-day moving average. Consider the following chart below of the S&P 500 Index from January 2005 to July 2007 leading up to the bull market peak just prior to the start of the financial crisis.

On four separate occasions during this two-and-a-half-year period, the S&P 500 broke below its 200-day moving average, only to find support and bounce at its 400-day moving average. This is just one of many examples throughout history of this support playing out, as it also occurred on three different occasions from 2012 to 2014.

3. The slope of hope when the 400-day is breached. This is true even if the move below the 400-day moving average is decisive. The first key to consider when this break takes place is the slope of the 400-day moving average. If the pink line remains upward sloping, this means the ultra long-term uptrend remains intact and stocks still have the power to find their way back above this key support line. This is also true even when the 200-day moving average turns downward sloping and breaks below the 400-day moving average. For if the 400-day is still rising when the 200-day breaks below it, the probability is high that stocks will eventually regain their footing and resume their climb. Such was the case back in 1990 and again in 2011, not without some sincere investor anxiety along the way, of course.

4. The final escape hatch is the retest. Suppose we see the first three conditions breached. The S&P 500 Index falls below its 200-day and 400-day moving averages, and the 400-day moving average turns flat to lower as it is crossed to the downside by the 200-day moving average. Under these circumstances the bull market is no longer intact but instead is at risk of transitioning into a full-blown bear market. Suppose you are still invested at this point. What is an investor to do then?

The good news is that the stock market historically has always given investors one final chance to exit equity allocations before the lights completely go out. Consider the S&P 500 Index heading into the depths of the financial crisis in 2008. The stock market first peaked in July 2007, reached its final peak in October 2007 after a bounce from its 400-day moving average, subsequently broke decisively below its 400-day moving average by January 2008, and the 200-day moving average eventually crossed below an essentially flat 400-day moving average by April 2008.

At this point, we were already effectively nine months into the second-worst U.S. market correction in history by magnitude (not duration). But even with this fact, investors had one more chance to evacuate relatively unscathed before the lights completely went out. This came in May 2008, when the S&P 500 Index rallied right up into its 200-day and 400-day moving averages.

Sure, the S&P 500 Index was still over -8% lower from its all-time highs at this point, but it was generally on par with what would have been considered a post-tech bubble high as recently as a year prior in April 2007. And this retest provided a last exit to raise cash before enduring the additional 50 or so percentage points to the downside that would follow in the months after.

Such last exit retests have taken place during the lead in to every major U.S. stock bear market in history including in the aftermath of the stock market crash in 1929, as investors could have escaped largely unscathed roughly six months after the fact in April 1930.

“Sentimental gentle wind, blowin' through my life again,

Sentimental lady, gentle one.”

- Sentimental Lady, Fleetwood Mac, 1972

U.S. stocks remain the sentimental lady blowing through investor portfolios. And the bull market remains fully intact despite what has been a tough stretch as of late. Such pullbacks can be unsettling, however, particularly at a time when stocks have traded so well beyond fundamental expectations for so long. But investors can help resolve their uncertainty about getting unwittingly caught in the next major bear market by adding a few key colors to their investment market canvas. This way, one can look away from the market on any given trading day including the downside on Monday and know that the bull market won’t simply be gone.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Retirement Sentinel and Gerring Capital Partners make no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Retirement Sentinel and Gerring Capital Partners will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long selected individual stocks as part of a broad asset allocation strategy.