Stocks repeat patterns again and again though many refuse to believe they are caused by the same factors. One of the strongest influences on the market is emotion, either greed or fear, and stocks and the indexes set up patterns that show this greed and fear year after year, decade after decade. Many people think that with the information age investors are smarter and will react differently than in the past to the same criteria. Some do. They learn how to recognize the same patterns and what signposts to look for. Most do not. Every year new investors hit the market, eager to make their fortunes. They don’t have the experience and have not invested the time to learn or to follow someone who knows what to look for. Thus the majority of the market continues to make the same mistakes year after year after year.
When indexes get too extended, when the buyers are exhausted, then they will correct. It is usually a combination of factors that sets up the correction, but one rule of thumb to look at as you have noted is the percent rise above the 200 day SMA an index has made. If it gets too far ahead of the average it will start to struggle and then correct. We look at other factors as well such as distribution sessions, leadership action, and sentiment indicators, but one thing to always keep in mind is simply the magnitude of the rise.
With respect to SP500 and DJ30, historically they start to struggle when they rise 10% above the 200 day SMA. They start to correct when they get 15% above that key level. As for NASDAQ, it historically starts to struggle at 15% above the 200 day, and begins correcting at 20% above that support. In the late 1990’s NASDAQ would run 25% to 30% over the 200 day SMA before it would correct, but after the bust it has reverted to the historical levels. We remember in late 1999 and early 2000 that NASDAQ was 50% and more over the 200 day SMA and we were looking hard for signs of real trouble. They started showing up in February and March with massive volatility and rapid fire, alternating distribution and accumulation sessions. The season was changing, moving into a long winter.
At the recent highs, DJ30 was just 4% above the 200 day; SP500 was 6.7%; NASDAQ 10.7%. All of these are well within the general rule of thumb, and with overall good price/volume action, good leadership, and a solid uptrend, there was not a lot to sweat out. The market is still in the recovery stage from the base and can obviously rally higher as they breakout from the 2004 base. By contrast, at the January 2004 peak NASDAQ was 21.6% above its 200 day SMA. Correction time, and it surely occurred.