There has been quite a lot of talk about the major US indices trading below their 200 day moving averages. A large number of commentators who have brought it up have opined that this is the end of the cyclical bull market. It is important to note that some of those commentators have been bearish since the March 2009 lows. Sometimes it is difficult for humans to get past their ego (sense of being right/wrong), but in trading, there is no place for such at thing. I don’t have the numbers, but I would guess that a large number of bears who are pointing to the 200 SMA as a confirmation of the end of the cyclical bull are having problems with their ego. Most traders have had to fight tough battles with themselves over the psychological side of trading and chart reading, myself included. It is not my intention to make fun of chartists who are having problems with their egos, rather, I would like to point to a combination of moving averages that is better equipped at confirming the end of a cyclical bull market.

CLICK on charts to see them in full-size.

A simple chart with a 200 day SMA on it doesn’t really give us reason enough to doubt or confirm the end of a bull market. The arrows on the chart signify instances where the index has fallen below its 200 SMA (bull market false signals in green, bear market false signals in red).

Taking a look at the second chart, it is clear that the conventional combination of moving averages of the famous 50 & 200 SMAs is not good enough either. So what is an investor/trader to do? Take a look at the next chart.

The third chart is equipped with exponential moving averages. Simple moving averages are just an arithmetic mean, each price is given equal weight. Exponential moving averages give more weight to recent data (see this for more). In addition, the value of today’s EMA is calculated using yesterday’s EMA, hence EMAs reflect price action from the inception of what is being measured. This last fact is important when choosing what charting service to use as not all chart software is made equal. More on that here.

As the explanations on the last chart make abundantly clear, it is not always wise to use technical indicators you heard mentioned on CNBC or read in a blog. I’m not saying the combination depicted on the last chart is the best, but it’s something that I found works way better than what is being offered by most commentators. My take on the charts is that we are still in a cyclical bull market as the fast EMA has not crossed below the slow EMA. Market breadth indicators (something that I’ll talk about sometime in the future) have been negative for quite some time now and past experience suggests we are at or very near the bottom of this correction. If, however, the EMAs mentioned above manage to make a crossover, we would be facing another bear market.

Note: The S&P 500 has been depicted in a lighter color on the second and third chart to make the MA crossovers visible.

Following the €750 billion emergency fund announcements from Europe, the Federal Reserve announced that it was going to reopen the dollar swap lines for the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. This measure is supposed to help alleviate short term liquidity needs of commercial banks, in effect providing liquidity to the whole financial system.

This is something one would expect to be cheered, but for some reason, that is not the case. One needs to understand the the Federal Reserve is not trying to help Greece or any other Club Med with their sovereign debt issues, it is simply trying to avoid contagion, id est a fire-sale of US dollar based assets. The last time non-US banks faced a dollar shortage, it resulted in a massive sale of everything and anything denominated in US dollars, including gold, which is regarded as a safe haven by many (including me). Back in the heyday of the dollar shortage of 2008-2009, the overnight lending markets literally fell to pieces – the charts of LIBOR and TED spread are a living witness to that. The Fed did its best to pick it up and it did a great job at it. The dollar shortage is the only reason the cyclical bear market that began in 2007 fell way off its downtrend channel. Anyone who is familiar with the 2007-2009 downtrend knows what I’m referring to. This time around, the Federal Reserve is trying to prevent the spread of the crisis to US markets. Remember, the sovereign debt crisis, as it stands now, is still only a European problem. The US with its massive national debt has not entered the stage yet and the Fed is doing its best to prevent this European problem from spreading to US markets.

Indeed, signs of a lack of liquidity have been all over the place recently. The previous swap lines were terminated in February (January-February sell-off, anyone?), the RMBS repurchases were halted in March and the LIBOR has been climbing a steep mountain along with TED spread. During all this time, the dollar has climbed to levels last seen during April of 2009 (also seen in October 2008). Indeed, the last time the US dollar climbed so fast was after the collapse of Lehman Brothers. One might even attribute last week’s intraday crash to problems with associated with liquidity, at least in part (more often than not, events like that need more than one catalyst).

All in all, it isn’t the least bit surprising to see the Fed reopen the swap window. One would take it for granted that the US government and the Federal Reserve wants to maintain the dollar’s position as the world’s reserve currency. If the dollar’s reserve status is indeed of concern to the Fed, it is only natural for them to open the swap lines. How would one expect the US to maintain that position if dollar based markets witnessed fire-sales every now and then? These dollar shortages wouldn’t be a concern if non-US banks weren’t so overly leveraged, but there isn’t anything the Fed can do about it, really. The only thing they can do is provide short term liquidity, which is exactly what they are doing. The advantages that come with being a reserve currency are numerous, but as this is not the issue at hand right now, I would rather not go into that right now.

Of course, with swap lines and other complicated measures directed at easing liquidity constraints, one can always expect to see a surge of uneducated claims from internet discussion boards as well as from politicians. One of the many claims floating around is that the American taxpayer has to pay for this. This is not the case as these dollars will be returned as the swap lines are terminated (the deadline for the new swap lines is January 2011). As per its name, a swap implies that something is given in return, in case of the ECB, the Fed receives euros and so with every central bank. More on that here.

Most of concerns, claims and accusations about the swap lines have been addressed in the FAQ sheet provided by the Federal Reserve, which can be accessed here. For additional information on swap lines, see my previous post and my free report on the previous dollar swap lines.

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Quote of the day from Swamp Owl at forexfactory:

No, I don’t buy that “this was an error, market is acctually ok, just a mistake – nothing to see here, move along, folks” propaganda. That “error” occured after DOW had already fallen 300 points and – people, how do you feel living in a world where large scale financial meltdown depends only on … just “N” on keyboard separating b and m. That’s pure absurd.

Swamp Owl is right, of course. Furthermore, it makes no difference whether this was a genuine mismatch where bids fell off the table or a ‘mistake caused by a fat finger’. It tells us that markets are not rational and there’s not point rationalizing the kind of moves we saw. It doesn’t matter what or who caused the Dow to move 1000 points down from its open at one point. What matters most is what you will do if and when such a thing does happen. You can’t go wrong buying off a 9% decline when the market is in a primary bull market and the internals are in a relatively good shape for the intermediate term. Did you manage to catch a few bargains?

Carl Swenlin of DecisionPoint was interviewed this week by Jim Puplava on his weekly Financial Sense Newshour. During the interview, Mr. Swenlin gave his perspective of where he thinks the market is heading as well as provide a free trial username and password for the listeners of the show. I’ve had a look into DecisionPoint once before and it’s full of useful information. There are so many custom charts to give you ideas for a whole range of new trading systems. Market breadth indicators (new highs vs new lows, up volume, down volume etc) are what interest me the most, but there is a lot more to it that just that. In any case, if you are interested in the free trial, listen to the interview with Mr. Swenlin or send me an e-mail at kristjan[at]kristjanvelbri[dot]com (you have to make the e-mail address usable, the parentheses with sharp corners are to keep away spambots, who browse the web for e-mail addresses).