Option Advistor

Due to extraordinary market conditions, we are giving all readers immediate access to the most recent Option Advisor commentary.

The following is a reprint of the market commentary from the October edition of the Option Advisor, published on September 25. Prices and the chart are as of the close on September 25.. For more information or to subscribe to the Option Advisor, click here.

When it comes to the use of charts in making investment decisions, I agree with William X. Scheinman, the author of a very astute and little known book entitled "Why Investors Are Mostly Wrong, Most of the Time," in which he writes:

"I use charts in my own work, for I believe it is no coincidence that certain market advances and declines reverse themselves at certain technically defined points. But I don't regard technical trendlines and patterns as sacred, nor do I think they should dictate investment decisions. Charts are a vital tool in such decisions, but only when integrated with fundamental data and psychological measurements."

The accompanying monthly chart of the S&P 500 Index (SPX) with its 80-month and 160-month moving averages is an excellent illustration of the value of charts in identifying those "technically defined points" at which "advances and declines reverse themselves." I have found these very long-term moving averages to be outstanding lines of demarcation that help us answer such critical questions as whether a decline represents a pullback in a bull market or whether a bear market has taken hold. I consider a break by the market below the 80-month moving average as representing a shift into bear-market mode, and a failure to hold at the 160-month moving average as indicating the potential for a downward spiral of very serious proportions.

Note specifically from this chart how the S&P's break below its 80-month moving average on a monthly closing basis in May 2002 was followed by a decline of more than 25% into the July 2002 lows. This was followed by successful tests of support at the 160-month moving average in July and October 2002 and in March 2003. Note also how the 80-month moving average acted as resistance for much of 2004 and 2005, until it was finally taken out ahead of a 25% bull-market rally from October 2005 through October 2007.

Fast forwarding to our current situation, the pullback from the October 2007 market peak has yet to generate a monthly close below the 80-month moving average, although we have penetrated the 80-month on several occasions this month. In fact, the S&P came within 6 points of touching its 160-month moving average at its recent low on September 18. The situation is quite tenuous. At today's close of 1,209, the S&P is less than 1% above its 80-month moving average at 1,198 and 7% above the 160-month at 1,124. So it is certainly conceivable that we can get an end-of-month close early next week below the 80-month that would place us in bear-market mode. And an even more ominous move below the 160-month is within easy striking distance in this volatile environment.

While the relationship of the S&P to these moving averages is by no means an infallible indicator of future market movement, it does provide us with good historical context and a reasonable benchmark for determining whether we are currently in bull or bear market mode. But there is a significant additional concern should the market cross the line into bear territory, as such a move would call into question the contrarian significance of various indicators of investor sentiment. For example, the CBOE Volatility Index (VIX) has already rallied up to and beyond levels that have been consistent with market bottoms over the past year. But these market lows have all been within the context of bull-market pullbacks. In a bear-market environment, where bearish sentiment becomes the norm rather than an aberration, a VIX peak at 42 could be insufficient as a market bottom indicator.

There is no doubt that sentiment - both quantitative and anecdotal (just look at the doom-and-gloom covers of the business magazines and the news weeklies) - is bearish and that there is a lot of fear in the air. But it is unfortunately the case that while bearish sentiment in a bull market invariably presents a buying opportunity, in a bear market we are faced with the very difficult problem of attempting to determine whether or not bearish sentiment has reached the "blood in the streets" extreme that can give us an "all clear" signal. This lends an additional layer of importance to the market holding at these key moving average lines of demarcation.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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