Breaking Below Support Levels

10/06/2008 10:00 am EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, says the market's recent drop below long-term moving averages is very troubling.

I have found 80-month and 160-month moving averages outstanding lines of demarcation that help us answer such critical questions as whether a decline represents a pull back in a bull market or whether a bear market has taken hold.

The Standard & Poor's 500 index'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.

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 pull back from the October 2007 market peak [for the first time] generated a monthly close below the 80-month moving average, (at 1,198). (It closed last Tuesday, September 30th, at  1164.74.)

In fact, [two times last week the S&P actually dipped below] its 160-month moving average (at 1,124).

An end-of-month close below the 80-month [moving average] places us in bear-market mode. And an even more ominous move below the 160-month is within easy striking distance in this volatile environment. A failure to hold at the 160-month moving average indicates the potential for a downward spiral of very serious proportions.

But there is a significant additional concern [about crossing] 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 an indicator of a market bottom.

No doubt sentiment-both quantitative and anecdotal (just look at the doom-and-gloom covers of the business magazines and the news weeklies)-is bearish and there is a lot of fear in the air.

But unfortunately, 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.

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