You may have read my recent article on crude oil using Moving Average Envelopes, a technique I learned back in the 1970s from the late Leon Brand, a talented technical analyst at Merrill Lynch. Today we will use that same approach as well as the Advance-Decline line to analyze the stock market. We will also use price momentum and take a look at Dr. Copper.
Leon used to run a simple 12-month moving average and then add large percentage bands around the average line. For currencies Leon used 12.5% above and 12.5% below the average line and the results were impressive. These wide bands can typically produce one to two signals per year -- ideal for someone with a long-term perspective. When prices reach the upper band of the envelope it is time to take profits and perhaps short the instrument and when the lower band is reached it is a time to be a buyer. The percentage around the 12-month average line is found by empirical research -- plugging in numbers until you get an acceptable result.
In the monthly bar chart of the S&P 500 Index, below, we can see how a generous band around the 12-month moving average line can produce long-term buy and sell signals. A sell or take profits signal comes when prices reach the upper band of the envelope and a cover shorts or buy signal is given when prices reach the lower band of the envelope.
In the past few months we can see the sell signal and just last month the buy signal. Prices may not resume the long-term bull market as we may fail at the 12-month average line or before reaching new highs for the move up.
The Advance-Decline Line (AD Line), chart below, is an indicator that has been around since the 1920s and was created by Col. Leonard P. Ayres who tracked the number of securities that closed higher versus the number that closed lower. It was a constructive day when more stocks rose than declined. This indicator has a history of peaking some four to six months before major market tops.
This weekly chart from Bloomberg shows a peak in September. The AD line has moved lower but is now poised to break its downtrend. This will help on a short-term basis but does not signal a return of a bull market.
Momentum has turned up and that argues for further improvement. The AD Line needs to move to a new high to be impressive and I doubt that is going to happen.
In this third chart from Bloomberg, below, we show the number of 52-week new highs. Notice how the number was shrinking the past year ahead of the fourth-quarter decline. This downtrend is poised to be broken and we should see the new high list expand again.
Copper futures can be used as a leading indicator of the economy. Traders use it all the time as a short-cut or quick read on the economy. If copper prices are rising it must be because the demand is strong. If copper prices are sliding it must be because demand is poor. Maybe too simple, but for many traders it seems to work.
Right now it looks like there is a bullish divergence with copper prices making equal lows and price momentum making a higher low. This could be foreshadowing higher copper prices ahead. We'll see how this plays out.
In this chart of the Dollar Index, below, we can see that prices are just above the 12-month moving average line. Weakness in the dollar will help lift copper prices (everything else being equal) and probably crude oil prices, too.
Bottom-line Strategy: Stock prices endured a very scary fourth quarter but after touching the lower band of the envelope the S&P 500 is likely to trade up the next few months. After that, however, the bear could well return.