Wednesday, January 16, 2008

How bad can things get?

With markets either in, or about to start, cyclical bear phases I took a look at the extent of the damage which could follow. I started with the semiconductor index (well, the Semiconductor HOLDRs, SMH) as this was the index most hit by the selling in recent months. I looked at the relative percentage difference between the 50-day and 200-day MAs as this removes some of the short term volatility which can skew daily extremes. The SMH only has 6-years of data, but there is evidence to suggest worse could follow.

However, like an elastic band, ever swing to one extreme tends to be followed by a counter move of similar weight in the other direction. During the bear market bottom and bounce, the relative difference between the two moving averages reached extremes of +36% and -27%. The current difference is a paltry +11% (but a bounce could see a 50-day MA rise 8% or more above the 200-day MA).

With the S&P it is possible to look back over the last 50 years. Even here it is apparent we haven't approached anything like a significant divergence. The current difference between the 50-day and 200-day MAs is only 1.6%, but significant counter moves tend to occur when the difference between the averages pushes out to 10% or more.

The alternative scenario to consider is that markets are still in cyclical bull phases, where major divergences between the 50-day and 200-day MAs are unlikely. However, it would be hard to argue for a cyclical bull phase in the Semiconductors and Russell 2000, and it may not be long before large caps join the aforementioned indices into more protracted declines.

Something to consider in the months ahead.