Considered even in the brief context of 2011 alone, this past week’s SPX selloff is no big deal. The stock markets have been meandering in a broad trading range all year, surging up when traders feel optimistic and slumping down when they feel pessimistic. Understanding the SPX’s ongoing consolidation is crucial to recognizing the awesome buying opportunities these weak stock markets have created.
The flagship S&P 500 stock index is the best representation of the US stock markets as a whole, as well as the performance benchmark for all stock-market professionals. Despite some big swings, on balance all this SPX has done in 2011 is grind sideways in a high consolidation. This trading range’s overhead resistance has been around 1340 in SPX terms, while its foundational support has crystallized near 1270.
Consolidations exist because sentiment, how traders as a group feel about the markets, gets out of balance. After stocks rally far enough and long enough, traders forget the markets are risky and grow too greedy. This happened after the powerful 30.2% SPX upleg between late August 2010 and mid-February 2011. By the end of this awesome 6-month run, traders feared nothing and assumed stocks would keep rallying indefinitely.
But the SPX was very overbought, stocks had rallied too far too fast to be sustainable. By February this index was stretched 15.2% above its 200-day moving average! The SPX’s relationship to this critical technical line is rendered on this chart in the form of the Relative SPX in light red. It is simply the blue SPX line divided by its black 200dma line. The resulting multiple charted over time forms a horizontal trading range, as explained in depth in my essay on Relativity Trading.
Over the past 5 years, the SPX has generally topped when it stretched 10%+ beyond its 200dma. So 15% in mid-February was pretty extreme. I warned our newsletter subscribers about this at the time, and we realized big profits in our commodities-stock trades that had been added in the summer of 2010 the last time traders were afraid. And indeed, after hitting a new post-panic high of 1343 in mid-February, the SPX soon plunged in its first pullback of 2011.
Though it was the Libya revolt that acted as this selloff’s original spark, the particular catalyst that initially sends an overbought market lower is irrelevant. If catalyst A hadn’t driven the necessary selloff, then catalysts B or C soon would have. There is always plenty of good news and bad news out there for traders to digest, so they can easily spin prevailing newsflow to rationalize any buying or selling.