Is S&P 500 starting a bear market?
In this last period, I read on many financial web sites some warning comments about the potential and imminent starting of a bear market on the S&P 500. The main point that these sites show graphically, is the rising trend of the index from 2009 and the price break of a short term trend line togheter with a medium term oscillator reversing (graph 1, A and detail in B). Other websites point out a downside breakout of a short term simmetric triangle (graph 1, C).
I think that we could understand what is happening on the market with the use of the same approach, but from a different point of view.
In fact the graphs shown on the financial websites, are built with a linear (arithmetic) price scale. From a technical analysis point of view a logarithmic price scale is preferred, when we have long term charts (more than a few years), or when generally we have the index price range over the period being investigated greater than 20% (1). The difference between the two scales, is that the first, the linear, is plotted in such a way that the values on the scale are spaced equidistantly. Each unit change is represented by the same vertical distance on the chart, regardless of what price level the asset is at when the change occurs. The logarithmic scale is plotted in such a way that two equivalent percent changes are represented by the same vertical distance on the scale, regardless of what the price of the asset is when the change occurs: see for a more detailed description the link on note (2).
From a practical point of view, the log scale allow me to see if the trend is maintaining a sustainable price growth, in terms of percent change vs. time passed, or it is starting to become weak. And this is a leading indication vs. the lagging linear scale. Let’s look to a real example comparing the S&P 500 with the two scales.
As you can see, in the log scale the price broke the dinamic uptrend line some months ago. It is the same that happened in the 1995/2000 bull market, as shown on the next graph:
But when prices broke the dinamic trendline of the log scale in the graphs 2 and 3, we have two very different behaviors between buyers and sellers. Yes I’m speaking of behaviour because the price graphs of an index is just representative of what is happening between these two classes of investors. And we must also consider that in those classes we have in the last years a more intense activity of Central Bank and algo-trading that could influence in a different way the pattern between buyers and sellers.
The big picture in logarithmic terms, says that the dinamic trendline has been broken, but this is not enough to say that a bearish trend is started, as Dow Theory explains. We need that the price line must create a lower high and a lower low under the last low that is situated at the price level of 1800. But another consideration is that the end of a bull trend is not the prelude to the beginning of a bearish trend: there are also lateral trends. And this could be, for the moment, the more probable case: historically speaking, trading range markets are present in the 70% of the cases, and trending markets only in 30%.
As you can see in the graph 3, the 200 day moving average is a good indicator of a starting bearish trend when its inclination reverses from positive to negative: this has been the case both in the 2000 and 2008 bear markets. But, as you can see in the present situation in graph 2 and graph 4, the moving average is moving sideways with a slight positive inclination. So for the moment we have a flat moving average with its prices crossing up and down in a choppy high trading range market.
Zooming the chart in a shorter term time frame, we can see that the price were confined in a trading range recently upside broken in the last weeks: the upside channel trendline seems to be a good support for the moment. But if we have not enough strenght in the prices (remember the medium term oscillator reversing in graph 1, symptom of price weakness), they can down turn in the trading range, and we must carefully watch the support level in the 2000-2050 area (about -6,5% from the current close), were we find the 200 day moving average and were we have the most part of closing days in the last two years. From a longer term point of view, there is an important support level around 1800 (about -16% from the current close).
If we consider Fibonacci retracement, the bottom of the channel is near the 23,6% retracement level, and the 38,2% retracement level coincides with the 2007 and 2000 market tops.
In conclusion
The use of logarithmic scale on the S&P 500 Index is telling us that the bull trend it is already exhausted from several months and we are now in a sort of choppy market;
The price are near a support level represented by the upside channel line of a trading range started two years ago. If this line will be broken, we have a next support level around the 200 day moving average zone at 2000-2050 and an important support level around 1800: it is this level break that could be the real prelude to a bear market trend. Another important support is at 1600;
As the price stay on the top of the channel but without a good strenght, from a risk/reward ratio point of view the opportunity for gain is greatly outweighed currently by the possibility of capital drawdowns: the range of the channel is very wide, with an excursion about 16%;
In case of consolidation in the next period, the bull trend might resume.
- http://www.investopedia.com/ask/answers/05/logvslinear.asp
- C. D. Kirkpatrick and J. A. Dahlquist, Technical Analysis: The Complete resource for Financial Market Technicians, II ed., 2011, pp. 220-1.
Mario Valentino GUFFANTI
CFTe – SAMT Vice President – Swiss Italian Chapter – mario.guffanti@samt-org.ch
Disclaimer: the above article is for general information and educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
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