There was some consternation among equity bulls when the S&P 500 violated its 200 dma as it could have been the signal of a major bearish episode.
Technical analysts offered some relief when they pointed out that it’s the slope of the 200 dma that matters. The historical evidence shows violations of the 200 dma when the moving average is just a correction in an uptrend. However, an index that’s trading below a falling 200 dma is a warning flag that a bear market is under way. The arrows in the accompanying chart show the occasions when the S&P 500 fell below a falling 200 dma. Often these signals occurred when the index violated a rising moving average, which later turned down, marked by the red arrows.
The bulls may have felt vindicated when the S&P 500 regained its 200 dma late last week. This episode is a lesson for investors to regard similar circumstances as a buying opportunity. But that’s not the entire story as the market is becoming increasingly bifurcated.
This chart shows the S&P 500, NASDAQ 100, Dow Jones Industrials Average, the mid-cap S&P 400 and the small-cap Russell 2000 with their respective moving averages. The good news is the S&P 500 and the Dow regained their 200 dma. While the S&P 500 moving average has been rising, the same isn’t true for the Dow. The NASDAQ 100 is holding above its 200 dma. The bad news is the S&P 400 and the Russell 2000 are below falling moving averages. The strength of the S&P 500 has been held up by megcap growth stocks. In the absence of the effects of megcap growth, the other major U.S. equity averages are signaling bear markets.
How you position yourself in light of this bifurcation in market internals depends on your time horizon and whether you are a momentum or value investor.
The 200 dma study
Beyond the eye test of the rising and falling 200 dma, I conducted a study of what happens if you bought the market when it violated its 200 dma during rising and falling moving average episodes. The study began in 1990 and ended in November 2023, and it was conducted using the following assumptions:
- Returns were capital returns and don’t include re-invested dividends.
- The study was based on non-overlapping periods, defined as the first instance when an index was both below its 200 dma and the moving average was rising or falling in the last 21 trading days.
The sample sizes varied, but they were large enough to draw conclusion. Here is how the S&P 500 behaved during 200 dma episodes when the moving average was rising and falling, as measured by the percentage of occasions when the index was positive or negative over different time horizons. These results confirm our eye test that violations of a rising 200 dma can be regarded as just a correction within an uptrend, especially over shorter time horizons. The differential starts to dissipate over six months and completely disappears after 12 months.
Similarly, here are the results the NASDAQ 100.
The results of this trading system when applied to the Dow show a more dramatic drop-off in percentage positive differential beyond six months.
In addition to a focus on percentage of occasions when the index was positive, I also studied the average returns under the conditions when the index was both under its 200 amd and the moving average was rising compared to when it was falling. The accompanying chart shows the return differentials of strategies of buying the index under the two different conditions. Return differentials top out at about six months and more or less disappear after 12 months.