This is going to be a quick post, but with all the focus that’s been given to the 200-day Moving Average I wanted to share a brief look at how I view long-term breaks of support. On Monday the S&P 500 closed below its 200-day MA after several tests of this key level as support. As with most tests of support and resistance, the more tests begin to weigh on the level holding. Think of it as bouncing up and down on a frozen lake, the ice begins to wear thin with each bounce, similar to supply/demand wearing thin in the market before an eventual break of the ice or break of support/resistance.
There’s a few things I look at with long-term support breaks like we’ve recently seen in U.S. equities.
- The initial break is less significant to me than how price acts after the break. What’s important with a support break is if that support becomes resistance going forward. This what gives us a glimpse at the type of market environment we are. When support becomes resistance we know the character of the market has shifted and a new trend has likely been established.
- It’s important to take a step back and evaluate the structure of the chart in terms of higher lows or lower highs that follow. This can show the broad formation of the trend in the market.
Okay let’s put this into better context with some examples.
- First let’s look at 2010 and 2011 when the S&P broke its 200-day MA. We can see that in both occurrences the Moving Average became resistance as price began to absorb some of the selling that occurred under and around this indicator. But its key to notice that following the tests of the 200-day price did not make lower lows. This is a good sign that a new down trend is unlikely to be forming as buyers are stepping in before price can break through the prior low.
- Then we have the breaks in 2012. These were quickly reversed as the market did not shift this support level into resistance. This tells us that buyers are still in control and the up trend remains established.
- Finally, we have the major market move that took place in 2007 and 2008. We had the first break of the 200-day MA in late-’07 as the market made (what would become) the first leg lower into a bear market. Then we had a test of resistance for the long-term Moving Average in early-’08 which was followed by a break to a new lower low in price. This lower low confirmed the trend change and that the structure of the market had in fact shifted
It’s important to conclude with the fact that the market is not required to follow one of the above three mentioned game plans. But I believe it’s important to have a mental model built to evaluate the changes in the market and how to handle important tests of support like this in order to eliminate an overly emotional reaction.
As of this morning, equity futures are positive and appear to be testing the 200-day MA price area before the market opens. Because of the amount of attention that’s being given to the 200-MA right now it’s likely to see quite a few trader orders and algos testing and feeling out how price is going to handle this break. Will it be a repeat of 2012 with a quick reversal back above? Or will we a test as resistance with another move lower.
