What to watch to decide what Friday's drop means for the trend in U.S. stocks

05/07/2012 2:02 pm EST


Jim Jubak

Founder and Editor, JubakPicks.com

So was Friday a one-day drop in reaction to the disappointing U.S. jobs numbers or the start of something worse?

On Friday as I cruised through my list of stocks that I’d like to buy or where I’d add to existing positions if the price is right, I kept coming to this conclusion: After a bad week, a large number of the stocks I find attractive are still hanging significantly above their 200-day moving average. To me that argues that the U.S. market hasn’t yet broken the upward trend that dates back to the November 25 low on the Standard & Poor’s 500 stock index at 1159. The index crossed above its 50-day moving average at the end of December, signaling an extended rally. Recently, since the beginning of April really, the index has been bouncing around that level, making the chart a pretty good summary of how uncertain this market has become.

But it hadn’t decisively tumbled through that 50-day moving average to signal a correction in that rally—until, maybe, Friday, May 4. The decline to 1369 put the index once again below the 50-day moving average at 1387. We’ve been down below the 50-day line to this degree before in April and have bounced back each time. Next week will tell us if we’re finally looking at a break below that support level.

Of course, I’ll be watching that level but the support level that will get even more of my attention is the 200-day moving average at 1277. The 200-day average is a very important level of support for this market since it says that there are a lot of investors who bought at that level or higher and who aren’t looking at losses until we get down to that level. What we know of investor psychology says that investors remain relatively reluctant to sell if they’re still looking at a profit in their holdings but become more willing to sell if that profit has turned to a loss. Seeing a loss, even a relatively minor one, increases our desire to avoid a bigger loss.

A move down to the 200-day moving average wouldn’t be pleasant—that level is a drop of another 6.7% from Friday’s close and with the other declines last week from the May 1 high at 1405 a drop to 1277 would take us to correction territory with almost exactly a 10% drop.

But it’s what happens at 1277 that is critical. If a drop to that level triggers a bout of buying from investors who have been waiting on the sidelines and who now decide that their favorite stocks are a bargain, then the 10% drop just gives us the correction that we’ve all been expecting and it would, quite possibly, form the foundation for the next upward leg in U.S. stocks.

In other words, we get a summer rally after a May correction.

If, on the other hand, a drop to the 200-day moving average resulted in increased selling as investors decided that stocks even at a 10% discount to recent prices weren’t a bargain, then I think the market is in for an extended period of weakness. Not a bear-market sell off, mind you, because such fundamentals as a 2.2% growth rate and 0.25% benchmark interest rates are still very supportive of U.S. stocks. And there is the expectation that growth in the United States will be stronger in the second half of the year. But a decline through the 200-day moving average could indicate that stocks are going to wander in the wilderness of summer this year.

Take a look at your own psychology and attitude toward your favorite stocks as an indicator of the wider market’s propensities. For example, I looked at Cummins (CMI), a stock I’m always looking to pick up on a drop, on Friday, when I noticed that the stock had dropped from $128 on March 19 to $107.11 at the May 4 close. That definitely put the shares below the 50-day moving average at $118.34 but left Cummins still above the 200-day moving average at $101.84. My reaction was that the stock wasn’t yet cheap enough—especially since Friday’s action had suggested that the market as a whole could be set to drop further. I decided to wait and see.

I had a similar reaction to many of the other stocks I looked at. General Electric (GE) had just barely broached the 50-day moving average at $19.47 when it closed at $19.34, but it was still significantly above the 200-day moving average at $17.34.  With a close at $95.87 McDonald’s had confirmed its recent break below the 50-day moving average at $97.54 but was still a good way above the 200-day moving average at $93.31. Middleby (MIDD) at $97.61 closed about $1.60 a share below its 50-day moving average but was still way above its 200-day moving average at $88.84.

My conclusion was that the bargains hadn’t yet become big enough to make me willing to take on the risk in this market.

I’ll be watching the 200-day moving average for these and other stocks to see if other investors feel the same way next week.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cummins as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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