Paraphrased from Investopedia and Wikipedia, mean reversion is a theory used in finance that suggests that asset prices and historical returns eventually return to the long-run mean or average level of the entire data set. The thought is that any price that strays far from the long-term norm will again return, reverting to its understood state. This mean or average can be the historical average of the price or return, or another relevant average… reporting services commonly offer moving averages for periods such as 50 and 100 days.
In my opinion, the historically strong “demand” readings for stocks coming off the 12/24/18 lows (frequently referenced in these reports and my webinars—please let me know if you would like to see the specifics again) suggest that, at this point, the probabilities currently favor normal consolidation and/or pullback periods. This is opposed to a full retest of the late-December 2018 low many market prognosticators discussed in writings and media appearances over the past weekend.
If the S&P 500’s (SPX/2783.30) low from last Friday of 2722 is violated, its rising 50-day moving average (DMA) may be one level of support for the SPX. In other words, if a violation of very short-term support at 2722 occurs, a mean reversion decline to the 50-DMA could easily occur—SPX chart below. Currently, the SPX’s 50-DMA is 2680. Please note that, due to its composition, the 50-DMA will marginally change each trading day. Additionally, Jeff Saut, Raymond James & Associates Chief Investment Strategist, quoted Leon Tuey in a recent report, who stated, “the correction will be rotational/time rather than magnitude.” Unless one of the following three guideposts occurs, I would agree with Tuey and think his viewpoint is consistent with a mean reversion move to the 50-DMA.
I am following three guideposts: 1) consecutive trading days when NYSE declining volume overwhelms NYSE advancing volume, 2) a violation of the rising 50-DMA / horizontal support (please refer to the chart below) or 3) various sentiment indicators returning to “extreme optimism” levels followed by a reversal down. If one of the three guideposts occurs, I may shift my focus to various retracement levels drawn off the move from the late-December 2018 low to the recent price high.
Finally, if the SPX decisively closed above resistance at 2816, the odds of a move towards 2900 and/or 2940 would increase—chart below. In the meantime, market participants may consider focusing on sectors exhibiting strong/improving relative strength, including Technology (select groups), Utilities and REITs. I will also be closely monitoring Communications Services and watching how the Industrials act if a definitive trade deal is finalized.
Last-minute Thoughts (not price-related): J.P. Morgan is asking, what are the big risks (headwinds) right now? The key near-term risks include:
1) Equity supply- The market could simply be overwhelmed by follow-ons (secondaries) and IPOs.
2) The U.S. Dollar- If the U.S. Dollar doesn’t take a break soon, it will become a more pronounced headwind for the SPX, EPS estimates and possibly Emerging Markets.
3) The mercurial president- Investors expect trade tensions to ease, especially with China. This is, however, by no means guaranteed, especially if President Trump is baited by the negative trade deficit headlines over the last week.
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Art Huprich, CMT
Chief Market Technician
Day Hagan Asset Management
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