Who's Afraid of S&P 500 Death Cross?

Last Thursday, I published a chart via StockTwits Chart.ly of the S&P 500 with its 50 and 200-day moving averages within a hair of crossing negative. The 50-day was sloping steeply downward at 1,285.91 and the 200-day had paused to flat-line at 1,285.71.

Many chartists or "market technicians" make much ado about this event. I think we should pay attention to it, but not for the same reasons. First let's take a look at this ominous foreshadowing of bear markets and lower stock prices.

At least one thing should jump out at you from this chart. The dreaded "death cross" occurred during last year's correction and, after stocks chopped around sideways a bit, the market went higher again as economic fundamentals trumped the technicals.

The other aspect I want to draw your attention to is the large empty space between the current "death cross" and last week's cluster of closing prices around 1,150. What I'm talking about begins with understanding that long-term moving averages are all about tracking the relatively slow pace and trajectory of price history.

And when price moves quickly and extensively away from the longer-term averages, I see lots of empty space on the chart for price to be attracted back like a magnet. Sometimes it snaps back almost as violently as it fell.

That's why I believe it is highly probable that the S&P will trade up to 1,250 in the next month or two, no matter how the potential for recession unfolds.

In other words, there are 2 or 3 equally likely scenarios about how and when the market and economy recover over the next 6 to 12 months to get us back over the "death cross."

But in any of them, I see the broad market retracing back up to at least touch the underbelly of the death cross in the next two months. This will be a nice trading opportunity I will capitalize on by selling puts on my favorite stocks now and by possibly trading some leveraged ETFs -- like the Direxion Small Cap Bull 3X (TNA) trade I did last week where I bought Tuesday (August 9) at $41 and sold Friday at $45.

The TNA ETF seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 2000 Index.

For my logic on why I see the S&P trading in a range between 1,150 and 1,250 for the next two months, see my August 5 piece "How Long Will Correction Last?" which I wrote as the market closed a second consecutive day right smack in the middle on 1,200.

Though I follow this tendency of markets to collapse and then trade back to resistance once despair seems permanent -- and I have nearly formulated it into a rule -- I didn't invent it. In statistics, this would simply be called tracking "reversion to the mean."

Voodoo Averages

During the financial crisis, I worked in one of the coolest epicenters of the ensuing volatility storms of 2008 and 2009. PEAK6 Investments is an options market making firm on par with Susquehanna (started by "Market Wizard" Jeff Yass) or Timber Hill (started by option pioneer Thomas Peterffy, who also created Interactive Brokers) or Hull Trading (started by options legend and 1970's black jack card counter Blair Hull who I interviewed in 2008 and who sold his firm to Goldman Sachs (GS - Analyst Report) in 1999 for nearly $500 million).

The primary source of profits for options firms like these is "volatility arbitrage" whereby they used sophisticated models and screens to find "high" volatility they can sell and "low" volatility they can buy.

They care little for whether a stock or index goes up or down, in most cases, merely using the underlying to hedge and reduce or eliminate directional risk.

When I joined PEAK6 to help them build their retail options education programs, I brought with me my technical charting and trading skills. To see what I focus on, check out my "Look Out Below!" piece from two weeks ago where I said "Next Target: 1,200," the day before the S&P cratered 4.8% in a single day from 1,260 to 1,200.

Anyway, I took some flack from some of the real quantitative options traders there for my charting "voodoo." I considered myself smart, but I really felt like the dumbest guy in the room sometimes among all the math majors and traders who ate statistics for breakfast. (I was the farthest thing from a math whiz in school and had to teach myself probability and statistics in my 30's when I became a professional currency trader. A quant I was not and I had to fight to learn the math fundamentals of trading.)

At first, their criticism bothered me, especially since I wasn't into all kinds of crazy stuff like exotic chart patterns and projections, or Elliot Wave and Gann, or Fibonacci extensions and measured moves. I just used moving averages to define and gauge trend and to reference extreme price reactions to tell me about the likely psychological reactions of market participants.

In fact, as a student of behavioral finance, I coined a phrase to describe what I'm watching on the chart that allows me to see into the "madness of crowds." I call my technical analysis "group behaviorism."

I'm not trying to predict precisely where the market will go. I'm just trying to establish probabilities and give favorable odds to the most likely scenarios in multiple time frames based on the mass psychology of the market -- be it hope, despair, or just plain disbelief.

Stat Arb

Then it occurred to me one day as I was talking to some quant option traders that they were doing the same thing with their volatility charts. While I looked at moving averages to tell me about trend and "mean reversion," they were playing with probabilities and projections using historical and implied vol lines.

We were both using statistical tracking of market prices -- in my case it was the underlying price, in theirs it was the actual vol of the underlying and the implied vol of option prices.

My bread and butter with charts was selling extremes of optimism and buying extremes of pessimism, looking for mean reversion. For the option vol trader doing "stat arb" (statistically-based arbitrage), the "buy" and "sell" might be associated with a different extreme as, for instance, they sell "high" vol associated with market panic.

But the idea of tracking with historical and current "means" to determine what is relatively "high" and "low" is the same.

So the next time that somebody tells you moving averages are useless "voodoo," show them this article and tell them to send me a note if they want to debate it.

I've already won the debate with some of the best options traders in the world. I'm sure I can help anyone else see the light.

More importantly, let's be ready to take some shots for a rebound rally in September back up to S&P 1,250.

Kevin Cook is Senior Stock Strategist with Zacks.com

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