## Archive for April, 2008

### Cooking Tools #3: Using the CCI as a Timing Indicator

Wednesday, April 16th, 2008

Probably the most important decision regarding trading stocks is when to get into a trade and when to get out of it. Traders use many technical indicators to determine this. The more popular devices are moving averages, support and resistance levels, price patterns, and candlestick chart patterns. (Price patterns and candlesticks were the subject of Cooking Tools #1 & #2.) Today we’ll be looking at another tool to add to your arsenal of timing tools: the CCI which is short for the Commodity Channel Index.

The CCI was developed by Donald Lambert who introduced it in an article in the October 1980 issue of Commodities magazine (now Futures). It has since grown in popularity and is used by traders to identify cyclic trends not only in commodities, but in equities and currencies as well. Although it works best in cyclic markets, it can be also be used in trending ones too as we’ll see shortly.
What is the CCI?
The CCI is an oscillator and like most oscillators it is used to identify overbought and oversold conditions. It does this by measuring the relation between price and the mean deviations from a specified moving average:
CCI = (Price – Moving Average)/(0.015 x Mean Deviation)
Essentially, the CCI measures how far away price is from the moving average and how fast it moved to get there. If the price is right at the moving average, the CCI value will be at zero. The constant (0.015) is used in the above equation as normalizing factor. It restricts about 80% of the values to be between -100 and +100. The theory here is that when the CCI goes way outside either of those two boundaries, the stock is either oversold or overbought.
Most advanced charting services offer the CCI. On a chart, it is commonly represented by a series of bars that are centered around a zero point. (See chart below) The trick to setting up the CCI is in the choice of moving average. Lambert suggests using 1/3 of a price cycle where a price cycle is defined as the number of days (or other time unit) between successive price highs or lows. For example, if a stock makes a low about every 90 days, then a 30 day moving average is used. From my experience, however, sometimes you need to play around with it to get the best fitting moving average. Be aware that sometimes the stock will change its cyclic rhythm, so what time interval has worked in the past may not work as well in the future. (Note that most charting services use a moving average of 20 as the default.) The following is a weekly chart of the S&P 500 comparing a CCI with a 57 day moving average (which I derived from using price lows) with a CCI with a 20 day moving average.

How to interpret the CCI
There are two ways to interpret this oscillator–one as a straight indicator and the other as a divergence indicator. There are many ways that this can be used as a straight indicator. One way is to go long when the CCI rises back above the -100 level and to sell when it drops below the +100 level. However, this can lead to a lot of whip-sawing. A better way is to go long when the CCI crosses into positive territory (above zero) and exit the long position when it falls below zero. I like to wait a day or two on either side for confirmation before entering or exiting a position. You can see from the above chart that if you were long the S&P, the CCI(57) would have kept you long until this past January when it finally dropped below zero for two weeks.

But the divergence in the CCI for the months preceding the drop would have clued you in to the fact that the market was heading for a reversal. This is the other way to use the indicator. If the stock is making new highs but the CCI isn’t, the two are said to be divergent and a price reversal is on the horizon.
Another way to identify when a stock is greatly overbought or oversold is to look at the magnitude of the CCI. Extreme values–over +300 or under -300–signal that a stock has moved way beyond its moving average making a correction highly likely. This “tell” is especially useful if you have a short position. Any move off an extremely negative CCI number is a signal to cover.
Day traders will find the CCI to be a useful entry and exit tool, too, especially if several time-frames are viewed simultaneously. I used this method along with other indicators to daytrade the S&P Emini futures. It took me a month to get the hang of it, but it eventually worked out very well (although it burned me out!).

Because it’s an oscillator, the CCI used by itself works best in sideways markets; in trending markets the CCI alone will lead to false buy and sell signals. This is when you need to loosen your interpretation of the indicator and only pay real attention to it when it crosses the zero line. Other indicators (like the ones mentioned at the top) used in conjuction with the CCI will help you to winnow the false signals from the real ones.

This has been a brief introduction to the CCI and by no means is it meant to be definitive. There are plenty of books on technical analysis that have expanded descriptions and uses of this indicator. Online, check out Woodie’s CCI club which contains a lot of info on trading with the CCI. (www.woodiescciclub.com)

### Good Golly Miss Mol(l)y!

Tuesday, April 15th, 2008

If you’ve been keeping up with the financial news you’ll know that infrastructure has been a hot topic in the past year or so. The reason for this is that emerging markets especially and China in particular are hastening to construct new roads, buildings, communications, etc. Their appetite for construction materials, natural resources, and equipment has been voracious and is expected to continue unabated for the foreseeable future. The stocks of companies engaged in providing these resources and services have, for the most part, been stellar performers and their names have become common via the financial media. But what hasn’t been covered much (at least to my knowledge) are the companies engaged in the mining and refining of molybdenum, affectionately known as “moly” in the metals industry.

What is molybdenum and why should we consider it from an investing point of view? Molybdenum is a metal similar in appearance to lead. It’s number 42 on the periodic table and has the sixth highest melting point of all the elements which makes it perfect for use in high-strength steel alloys. It’s mined in sulfide form as molybdenite. It can be mined as the principal ore but it’s also recovered as a by-product of copper and tungsten mining. Canada, the US, Russia, and China are the largest producers of moly. The metal trades as a commodity as molybdenum oxide. Only five years ago, the commodity was trading around \$8 per pound. It hit a high of \$40/lb several years ago, traded down to a low of around \$25/lb and has been rising steadily since then. It’s currently trading in the \$33-\$34/lb range.

Molybdenum has replaced tungsten in steel alloys because of its cost-effectiveness and effectiveness as a corrosion inhibitor. Because of its chemical and physical properties, it’s used in other alloys that operate under severe conditions such as aircraft engines, heavy equipment, and high-speed drills. It’s also used as a catalyst, lubricant, and pigment.

Currently, the supply of moly is meeting demands, but a shortfall is imminent according to some reports. Western demand is increasing by about 3% annually; globally, it’s about 4.5%. The projection for demand in China is for a 10-20% annual increase. Add to that the fact that there are 48 nuclear reactors scheduled to be built by 2013 and 100 by 2020 which will require between 500,000 – 800,000 pounds of moly (used in the steel alloy) depending upon reactor design. One thing is for sure, if mines don’t step up production there will be a shortage in the near future.

So what publically traded companies are actively engaged in moly mining? There are two companies devoted exclusively to moly mining:

Thomson Creek (NYSE; TC): Owns and operates mines in the US and Canada. It changed its name from Blue Pearl late last year.
General Moly (AMEX: GMO): Changed its name from Idaho General Mines in 2006. Owns moly mines in the US and also holds gold, silver, and copper properties.

Other companies that engage in moly mining are Freeport-McMoran (FCX), Rio Tinto (RTP), and to a lesser extent Southern Copper (PCU), and BHP Billiton (BHP). There are two foreign-based moly miners that trade over the counter: Grupo Mexico (GMBXF) and Antofagasta (ANFGY) which is based in Chile.

All of the above mentioned stocks have been doing very well. My picks of the litter are Thomson Creek and Rio Tinto, but I don’t think you can go wrong with any of them. (Just be careful of the OTC stocks as they are very thinly traded.) Since February, Thomson Creek is up 43% and is trading at a new high; Rio Tinto has gained over 50% since January and is also threatening to make a new high. (Note that Rio is not cheap at \$477. Has anyone suggested a split?)

If you’re loathe to buy just one or two stocks, there’s a basic materials ETF (AMEX: PYZ) which includes PCU and FCX among its top ten holdings. Although this isn’t a pure moly play, you do get the benefit of diversification across the materials sector.

So let’s make some profits from Miss Moly, by golly!

### Sovereign Bank (SOV) — An Update

Monday, April 14th, 2008

Last month (March 13) we looked at Sovereign Bank (SOV) as being a potential candidate for an inverse head and shoulders formation. I was excited at finding it because as the normal formation is fairly rare in itself, the inverse pattern is even more uncommon. A colleague of mine, Carl, who heads a local hedge fund, said he didn’t quite share my enthusiasm. He was chomping at the bit to short the stock, citing lousy fundamentals. I said that it might be prudent to wait to see if the formation completes itself before initiating a short position. I don’t know if he took my advice, but his analysis of the company seems to have born him out.

At the time I profiled the stock, the chart had completed the left shoulder and the head, and was in the process of forming the right shoulder. I said that if the stock was able to trade above the neckline level of \$13.30, a long trade to the \$17-18 range would be viable. Unfortunately, the stock never did rise and the pattern was invalidated. Last Friday the stock traded under its previous low formed by the low point of the head (\$8.71) and is trading lower today. For me, this would have been the signal to go short.
So if you’re reading this Carl, kudos to you for the correct call! I bring this up to show that not every chart pattern works out as planned. You can see why it pays to be patient and wait until a pattern has completed itself before jumping in.

Friday, April 11th, 2008

Yesterday I gave a recipe on how to play stocks that have suffered at the hands of price-crushing news. I said that it was a highly speculative play but I forgot to give my reasons on why I felt that way. Usually when the stock drops on bad news, it has a tendency to keep falling. Sometimes the stock will rally back, luring investors into taking long positions, only to have it tank shortly thereafter. This can be a devastating trap. To avoid damage to your pocketbook, you need to be vigilant and watch the stock movement on a daily basis. You also need to have a firm stop/loss in place which is something that many investors don’t do even though they know better. But if you paper trade this strategy, read the news, and watch the charts, you’ll develop a feel for knowing when a trade set-up has increased profit potential. Also, it helps to select stocks in rising sectors or sectors that are at least not in decline. As the saying goes, a rising tide lifts all boats so it helps, too, if the overall market is trending upward.

At the end of yesterday’s recipe I said that I would illustrate this strategy with an example. The chart of Integrated Device Technologies (IDTI), a semiconductor stock, is a good recent example. Here’s its chart:

You can see the stock (along with the semiconductor sector) has been in serious decline, losing half of its value in six months, from last August to this January. The company reported third quarter earnings after the market closed on January 24th. Although their earnings were inline with estimates, their outlook for 2008 was lackluster, citing weaker demand for its products. Two analysts promptly downgraded the stock from a buy to a hold. You can see what effect all of this had news had on share price: the stock gapped down the next day on five times normal volume and remained at this level for several days. One analyst was quoted as saying that the bad news was already out there, and apparently investors started feeling the same way as the stock began to rise. Ten days after the drop, the stock broke its flush-out day high point. This was the day to take action. The following are two scenarios that could have been employed. (Note: All prices quoted are closing prices. Commissions and fees are not included.
1. Buy 100 shares of stock @ \$8.02/share = \$802 initial cost
Current price: \$9.80/share (\$980 total value)
Gain (unrealized): 22%
2. Buy 7 May 7.5 Calls @ \$1.05/contract = \$735 initial cost
Current price: \$2.40/contract (\$1680 total value)
Gain (unrealized): 129%
You can see that buying calls would have been much more profitable than if you had just bought the stock, which is usually the case. However, if the stock drops below \$7.50 by the third Friday in May, you will lose all of your investment. This is the risk of buying options.
If I had just bought calls, I would probably do two things at this juncture. If I was still bullish on the stock (and there’s no reason not to be since it’s still trending upwards), I’d roll-out my calls by selling the ones I have now and buying new calls at a strike price of \$10 several months out. The reason is that about a month near expiration, options begin losing value due to time decay. The August 10 call is now being offered at \$0.90 which would give me a net profit of \$1.50/contract should I elect to do this.
If, on the other hand, I had only bought the stock, my action today would be to buy some puts as protection. Buying one May 10 Put contract at \$0.60 would lock-in my profit. If the stock declines, the rise in value of the put will protect my position. I could also buy the May 7.5 Put at a nickel. Although this would help reduce my loss should the stock tumble below \$8/share, it wouldn’t protect me entirely. (If an \$8 strike price was offered, I’d buy that.)
There isn’t time nor space to go into every trading strategy I mentioned yesterday. My goal was to show you how the trade sets-up and to give you a taste of how to profit when a lemon cookie does drop into your lap. Happy snacking!

### Tuning into the Media

Tuesday, April 8th, 2008

Every day my financial inbox is crammed with newsletters, market updates, and the usual spam. Since my lackey Dimitri refuses to read them, I’m left with the task, and I have to say that I don’t really enjoy most of it and usually try to find something else to do as well. However, there are a few that I find to be worthwhile and one of them is from a company called Investment U.* (Disclaimer: I have no personal or professional affliation with them.)

Yesterday’s newsletter featured an article written by Floyd Brown concerning the status of the media sector, in particular radio and print. He is a contrarian, meaning that he buys stocks when everyone else hates them. How do you know when a sector has been grossly oversold? You know when you see articles in newspapers and magazines and the talking heads on financial news shows saying there is no hope for it. That, claims Mr. Brown, is currently the case with radio and print, and I might have to agree with him. Stocks in this sector are down 30-80% since a year ago.

But where my views digress with his are in the stocks themselves. He thinks that Clear Channel (CCU) is a screaming buy below \$30 and gives very good reasons why. Despite a negative article in Fortune saying that Clear Channel’s prospects are grim, the company grew revenues over 5% last year. They are starting to sell their underperforming assets (they sold 217 non-core radio stations just this February), and if they were to sell their billboard advertising business, Mr. Brown claims they could wipe out their debt. He says the company is a steal below \$30. Maybe so, but looking at the chart, I’d wait until it goes back up to \$30. Actually, I’d wait until there’s some confirmation on the lawsuit mess they’re in concerning their bank and private equity buyout which probably won’t happen until the case goes to court in early May.

In addition to Clear Channel, Mr. Brown also likes Time Warner (TWX), Citadel Broadcasting (CDL), and Gannett (GCI). He says that the upcoming presidential elections as well as the Olympics will increase the earnings of these media giants along with their share prices. Sounds reasonable to me. My pick of these three is Citadel. The stock has lost over 80% of its value in a year and is now staging a comeback. Last year’s acquisition of the ABC radio network along with the resignation of their CFO late this January has burdened the stock, but the company’s plans for major restructuring of its radio stations is looking like it’s starting to pay off. Time Warner looks like it just put in a double bottom and needs to push through its \$15 resistance level for a rally there to be confirmed.

Other stocks that look promising:
The best looking charts among the more heavily traded stocks in the broadcasting group are the following:
EMMS – Emmis Communications: The chart showed not one but two bottoming tails in January and the stock has risen steadily, up 47% since then.
CMCSA – Comcast: The stock is up 25% since its January low and is bumping up against resistance at \$21.
WON – Westwood One: This chart, similar to Emmis’s, has been steadily advancing and broke out of resistance.
DISH – Dish Network: The stock looks to have put in a double bottom and is pushing against minor resistance. If it can start filling the gap at \$33.50, I think it’ll be heading northward for a while.
DTV- Direct TV: This stock took a nasty tumble last fall, staging an incredible 44% comeback since January. It’s now trading at its pre-tumble level. I’d be a buyer if it falls back to its \$24 support or breaks overhead resistance at \$27.

For the moment, I’d leave Sirius (SIRI) and XM Satellite (XMSR) alone until their merger is finalized. The stocks are just too volatile, although if you want to play one of them, my pick would be Sirius as it’s closing in on its \$2.65 major support level. Also, it seems to have the most to gain from the merger. I’d also leave the print sector alone as many of the stocks are just now putting in bottoms…or are they? The New York Times is the one bright spot, enjoying a 28% gain since January.

I do agree with Mr. Brown that the rumors of media’s demise are greatly exaggerated. I mean, these guys are no dummies, and I’m sure they’ll find ways to streamline and reinvent their business models that include more of the emerging media technologies on the internet as well as in the marketplace. It’s time for us to tune into these companies.

Now back to your regularly scheduled programming…

### Earnings Etouffe Candidates

Monday, April 7th, 2008

Since today officially kick-offs earnings season, I thought I’d go back to my first recipe, Earnings Etouffe, to see if we can’t come up with some candidates for this strategy. The essence of this strategy is to identify companies who have raised guidance and then either buy the stock or buy call options on them. The stock or option is then sold just before the earnings release date. (For more info, see Recipe #1.)

Although there have been many companies that have recently raised guidance, the following table lists the ones that I felt had the most compelling releases, meaning that they raised guidance significantly more than most. Note that the earnings date followed by an “a” means that the company will be reporting after the market closes; a “b” means that they’ll be reporting before the market opens; and a “u” means that the date is still unconfirmed. Companies will issue press releases to state exactly when they expect to report earnings, so if the date is unconfirmed, keep checking their press releases.

Which ones do I like? All the companies listed above have been doing well, and I’d be a buyer on any sort of pull-back. The only stock that concerns me at the moment is FCN. It’s been in a down-trend for the past week and is closing in on its \$62.75 support level. If it breaks that, then I’d wait until it turns around. Also, the chart of MANT shows recent volatility despite its long-term upward bias so if you want to play this stock, I’d wait for it to swing down to the \$42-43 level. All of the above stocks are optionable except for PPO, and if you do decide to go the options route, make sure that the stock has liquid options (open interest > 100-200).

Note that this strategy is really only as good as the overall market. If indeed this is the beginning of a bull market, the likelihood that this strategy will pay off increases along with the strength of the bulls.

Now go out there and whip up some earning etouffe!

### Are the Home Builders Constructing a Comeback?

Friday, April 4th, 2008

CNBC this morning gave a quick report on the current rebound in the homebuilding stocks. Since I ‘ve been busy getting my taxes together (argh!), I thought I’d take the easy way out today and look at this sector in more detail. The credit crisis took a wrecking ball to these stocks, with many of them losing 70-90% of their value in a little over a year. That’s ugly. But recent Fed easing moves and with Congress getting into the act, the crisis looks like it’s starting to abate. This could bode well not only for home buyers but home builders as well.

So, what are the charts of the home builders telling us? Naturally, one would expect major similarities among them, and there are. Most of them formed double bottoms in November and January. From their January lows, the stocks quickly sprung back until the beginning of February when they began oscillating in a trading range. The chart below of Standard Pacific (SPF) typifies this behavior.

In just the past few days, the following stocks have broken short-term resistance levels: SPF, Meritage (MTH), Beazer (BZH), M/I Homes (MHO), and Lennar (LEN). Those that have just broken short-term resistance and are approaching their next resistance levels are Ryland (RYL), Hovnanian (HOV), Toll Brothers (TOL), and Champion (CHB). Those nearing or butting up against resistance are Brookfield Homes (BHS), D R Horton (DHI), KB Home (KBH), Pulte Home (PHM), and Centex (CTX). If you’re itching to get into these, I’d go with the those in the first or second group above. These stocks in general have been volatile and I particularly don’t like the action in CHB. It’s subject to extreme oscillations which is why it wouldn’t be one of my top choices. Note that some of these stocks do pay dividends, with LEN, BHS, DHI, and KBH having dividend yields between 2.3-3.7%.
Hopefully these stocks are out of the basement and from here they can build us some profits!
Update on yesterday’s candlestick play:
XRIT’s hammer formation is invalidated as the stock is trading below yesterday’s close. Now you can see why it’s so important to have the follow-through day.

### Candlestick Trend Reversal Patterns: Chart Examples

Thursday, April 3rd, 2008

Yesterday I introduced the concept of using certain candlestick patterns to identify potential reversals in price trends. These patterns included shooting stars and hanging men which occur at the end of an extended rise in price and signal a bearish reversal. Scanning the charts this morning, I found one example that contains both of these patterns. It is the VIX, the volatility index. It’s customary for these candlestick patterns to occur on heavier than normal volume, but since the VIX is an index, there’s no volume associated with it, alas. I’m showing it anyway because it is just such a textbook example of these two patterns. Here it is.

You can see from the chart that both patterns are confirmed by the next day’s follow-through where the price (volatility) gapped lower. (As a note, hammers and shooting stars occur much more frequently that the hanging man which is why I used the VIX.)

The chart of Freeport-McMoran (FCX) provides not one but two classic examples of a hammer. A hammer will appear at the end of an extended decline, again on heavy volume. The pattern is confirmed if the next day is up, preferably gapping up at the open. In this scenario, the bulls are gaining the upper-hand and many times the follow-through day occurs on heavy volume as well because of short-covering. These criteria are all met in the following chart.

You should note that these patterns are formed after an extended price trend; if you see them in the middle of a trend, they usually aren’t very significant. Also, the charts of highly volatile stocks can produce false candlestick patterns, so be skeptical if you see a chart with a lot of topping and bottoming tails. As with all charting techniques, candlesticks aren’t one hundred percent accurate. With practice, you’ll be able to spot when a pattern is more likely to be valid than not.

I tried to find some charts today that looked like they might be setting up in one of these patterns. The only stock I found was that of X-Rite (XRIT) which looks like it formed a hammer today. The hammer isn’t exactly a textbook example since it has a bit of a top wick, but it did trade on five times normal volume. We won’t know for sure if the bulls are gaining control until tomorrow. Here’s the chart.

### Cooking Tools #2: Candlestick Trend Reversal Patterns: Hammers, Shooting Stars, and Hanging Men

Wednesday, April 2nd, 2008

If you’re a beginning investor, you’re probably looking at this title thinking that a candlestick is something used by Mrs. Green to off Colonel Mustard in the library. In the non-Parker Brothers world of investing (although successfully identifying chart patterns does involve a bit of detective work), candlesticks are a graphical representation of price and price patterns. Whereas a point and figure chart is represented by a series of vertical lines with horizontal handles that represent the opening and closing prices over a specified time period, a candlestick chart represents the same information but more graphically as illustrated in the diagram below.

The main portion of the candlestick is called the body. If the closing price is lower than the opening price, the body is typically shaded either black or red. In the reverse case where the closing price is higher than the opening price, the body is typically either white or green. (Some charting programs will let you select the colors for your candlesticks. I prefer the green/red schema.) The lines above and below the body are called the wick or shadow. They reflect the high and low price for that time period. Candlestick patterns are a graphical representation of investor psychology, and learning how to interpret them provides insight into market movement. Although there’s an entire field of chartology devoted to candlesticks, I’m just going to touch on a few of the more useful and predictive patterns, specifically those that signal a market reversal after an established trend, so that you will be able to identify them and know what to do if these patterns crop up in your charts.

Bullish Reversal Pattern: Hammers
When a hammer is formed at the end of a long price decline, you can bet that a turnaround is imminent, especially if the next day’s price action is to the upside. A hammer consists of a lower wick that is at least twice the length of the body and little to no upper wick. (A long wick is also called a tail.) The body of the hammer can be either color, but a white (or green) body is usually better. Why does this formation occur? During an extended down-trend, investors are understandably bearish. The stock opens and heads lower. Then the bulls step in and push the price of the stock back up, thus creating the long wick. The bears are now questioning whether the decline is still intact. A white body the next day would confirm that the bulls have taken control, especially if the price gaps up on the open. Note that the longer the bottoming tail, the more bullish the pattern. Here’s what a hammer looks like:

Bearish Reversal Patterns: Hanging Men & Shooting Stars
Let’s look first at the hanging man. A hanging man pattern looks exactly like a hammer, except that it occurs at the end of a long up-trend. The formation criteria is the same as well with the body at the upper end of the trading range. The color is not important although a black body is a stronger signal meaning that the bears are gaining control The pattern is confirmed if the next day is a black body or better yet, if it gaps down with a lower close. Again, the longer the tail, the higher the potential of a price reversal, especially if accompanied with higher than average volume. Typically, the volume on a reversal day can be quite large. Here’s what a hanging man looks like:

A shooting star is just like the previous patterns except that the direction of the tail (wick) is reversed. It, too, signals the end of a bull run. The criteria for formation are just like the hanging man. The signal is enhanced if it gaps up from the previous day’s close on heavier than normal volume. A lower open or a black candle the following day reinforces the fact that the bulls are losing control. Here’s what a shooting star looks like:

This is just a brief introduction to candlesticks. There are many books and websites that cover candlestick interpretation for those interested in learning more. I wanted to introduce these concepts to you because I’ll be mentioning these chart patterns throughout my blogs.

Tomorrow I’ll see if I can find some charts that illustrate these patterns so that, unlike Colonel Mustard, you won’t get clobbered by an errant candlestick should it appear in your stock charts.

### A Real Market Bottom or an April Fool’s Joke?

Tuesday, April 1st, 2008

The financial media this morning is exclaiming that the worst might be over and the market may finally be rallying. This may be true, but what do the internals have to say and what should you do about it?

Here’s what my charts are telling me. Today, the S&P did convincingly break through minor resistance as well as its 50dma (daily moving average). The VIX (volatility index) is bumping up against its 200dma which has been a major support level for it during this bear market. The Dow Transports (DTX), viewed as leading indicator of market direction, also broke through its 490 resistance level and is nearing the next point of major resistance at 500. The Dow Industrials, the Nasdaq, the S&P 100 (OEX), and the NYSE composite (NYA) are all also threatening to take out their resistance levels.
Sounds rosy, doesn’t it? But hang onto your wallets thar’ pardner, ’cause if you’re a long-term investor, it might behoove you to wait. The reason can be demonstrated graphically by looking at historical charts of the S&P during both bull and bear markets. The first chart is a weekly graph of the S&P 500 during the previous bull market. It shows the two and half years just before the market ran out of steam. You can see that the 50dma acted as a support level, and although it’s not shown here, it acted as a support level for the entire bull run.

The next chart is a continuation of the previous one and shows that now the 50dma has become resistance. Every time the market hit that point would have been a good time to short. You can see the market began its bear phase when it dropped below the 100dma, and began the next bull phase when it crossed above it in August of 2003. (Actually, the bull market could technically have been said to have started when it overcame major resistance earlier in April.)

The next chart shows the end of the recent bull market. Note that the 50dma acted as a support level here, too.

The final chart is just a short continuation of the previous one and it shows were we are today. Technically, the bear market began when the index broke its major support level of 1430 as well as breaking its 50dma. This January, it sliced through its 100dma which confirmed the bearish trend.

So what does all this mean? If you’re a long-term investor, you might want to wait a few days or weeks to see if the index breaks above its 50dma. Very conservative investors should wait until the 100dma is broken before piling into long positions. You may be giving up some profits by waiting, but on the other hand, you won’t be taking on additional risk.
You may have noticed that I included the CCI, the commodity channel indicator, in my charts. This is a good timing indicator that I’ll be discussing in an upcoming blog, and I want you to become familiar with it before we dissect it.
I guess we’ll find out shortly if today’s market action was for real or just another April Fool’s Day joke.