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The current up move that is occurring across many of the major equity indices around the world has many including myself asking, at least rhetorically, how far can it go? A long way if it is the beginning of a new bull market! However, let’s assume for this discussion that we expect some more bumps along the way before a new bull market takes hold.
The grey area in Figure 1 highlights this current move, showing how much more orderly recent moves have been compared to the market action in the many months preceding. As a side note, the markets compared – the DAX, Dow 30, SPI 200 and Hang Seng – have also moved in greater unison than in previous months.
Chart 1
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Often the best way to measure how much further a market might go in a particular direction is to compare it to its history. In this case, what is the most it has rallied during the current bear market? For this exercise, the SPI 200 (based on the ASX S&P 200) will be used, however the same approach can be used for any of the major indices.
First let’s look at the largest rally in either points or percentage terms. The largest points rally of 965 occurred from March to May 2008, while the largest percentage rally of 20.5% occurred from November to December 2008. Each of these are highlighted in grey in Figure 2. The corresponding levels have then been calculated from the March 2009 low and plotted on the chart. As you can see, we are already beyond the biggest previous rally of the bear market in percentage terms.
Chart 2
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This starts to build the picture. Now I’m going to look at it from another angle. Where is the market relative to its average? For this I’m going to use the Bollinger Bands. The Bollinger Bands allow us to see how many standard deviations a market is from its average.
The period used to calculate the ‘average’ for this test will be 50. There is no reason why this couldn’t be 40, 60 or 100 or many other numbers. However, the 50-period moving average is quite popular among traders and so will do just fine.
The next step is to adjust the standard deviation level until the upper bands match up with the most overbought level since November 2007. This level occurs at the May 2008 high, with the SPI 200 being roughly 2.125 standard deviations from its 50-day average.
What we see now in Figure 3 is that the SPI 200 is also beyond its greatest distance from the 50-day average (the orange line) for the current down move.
Chart 3
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Can the market rally further than it has previously? Absolutely! In fact that is one thing we should always expect – markets to fall and rally further than they have before. However, this gives a clearer picture as to where we are right now and the increased risks associated with entering new long positions at this time.
In my next article I will use the same approach to compare the current lows to important historical lows like September 11th, 1987, 1974 and 1929.
Happy Trading
Jordan Craw
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