Why You Should Be Concerned About A Break In The 200-Day

For much of Monday, the S&P 500 traded in a relatively narrow range with the market appearing to be searching for direction.

After a decline of more than 5 percent over the past few weeks, most traders were looking for a bounce. After all, every single time the market had "dipped" over the past three years, buyers had emerged and before long, the market had always wound up bounding to new all-time highs.

However, this time appears to be a bit different. And while stocks are indeed oversold and due for a reflex bounce, it is important to recognize that there are things happening in this pullback that were not present during all those dip-buying opportunities seen since the middle of of 2011.

The venerable index fell more than 30 points in the last 90 minutes of trading on Monday. There was no obvious catalyst to the latest swoon, save word that another case of Ebola had cropped up in Dallas.

However, there was a technical event taking place late yesterday that had not happened during the prior dips - and it did seem to attract a lot of attention.

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In short, the S&P 500 wound up decisively breaking below its still upwardly sloping 200-day moving average. And while history shows that such an event is actually a good sign for stocks in the ensuing weeks, there are an awful lot of folks that view the 200-day as the dividing line between a good and bad market.

As such, there were undoubtedly a fair number of sell algos primed and ready when the break occurred.

S&P 500 - Daily

Time to Bail?

For those who may be inclined to bail out of any and all equity positions based on the violation of the 200-day, you may want to continue reading.

First of all, the key to a break of the 200-day being a good "timing signal" lies in the direction the moving average itself is heading at the time of the break. You see, when the 200-day is moving higher, brief breaks to the downside actually represent pretty good entry points.

However, if the 200-day is itself sloping downward when the S&P breaks below, well, it's a different story. The bottom line is THIS is when you want to think about getting out of Dodge, if you haven't done so already.

Bears Beware: Not a Great Timing Signal in Near-Term

Regardless of which direction the 200-day is moving at the time of the crossing, history shows that such an event tends to signal an oversold market and is actually a decent buying opportunity in the near-term.

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In looking at the broad market, stocks have actually moved higher in the four weeks after a downward crossing of the 200-day moving average at a rate that is nearly three times higher than normal. And then over the next quarter, the market has outperformed the average 3-month return by more than double.

Something More Meaningful?

So, in the short-term, it appears that stocks are oversold and due for a bounce. And the history associated with a break of the 200-day would seem to suggest that the bounce could begin soon. However, the key question is if that move will represent a bottom to the corrective phase or simply a bounce within a more meaningful decline?

This question is represented in the weekly chart of the S&P 500 shown below.

S&P 500 - Weekly

The red circles on the chart represent the dip-buying opportunities since the mini-bear of 2011 that was associated with the ongoing Europe debt crisis and the downgrade of U.S. debt. The black circles represent the two meaningful corrections that occurred after the credit crisis bear market ended in March 2009.

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So, the question is whether or not the current decline will be a red circle or a black circle?

In looking at the charts of the other major indices for clues, the Russell 2000 continues to stick out like a sore thumb.

Russell - Weekly

To be sure, technical analysis is definitely more art than science and is a little like reading tea leaves at times. However, the message from the chart of the Russell 2000 is fairly clear as the current corrective phase is very different from the dips seen in the prior two years.

The Bottom Line

The current market environment continues to weaken. And while it can be argued that a fair amount of the recent carnage may have been a bit artificial and/or overdone, there is little denying the fact that this decline is different from what traders have become accustomed to over the past couple of years. Therefore, investors need to play the game accordingly.