Watch S&P’s 200-Day Moving Average Like a Hawk

Of all the signals that could provide a clue regarding the direction of the U.S. stock market in 2012, one of the most important could be the behavior of the S&P 500 with respect to its 200-day moving average.

Since breaking below its 200-day MA in August, the S&P has made three attempts at regaining this level with no success as of yet. At the same time, the 200-day MA has formed a broad, rounding top and has been headed downward for the past four months. While the S&P finally broke above its 200-day in explosive fashion Tuesday, investors still need to pay careful attention to what happens next. The last two times we saw a similar setup — 2000 and 2008 — the market was just months away from melting down. In another — 1994 — stocks were preparing for an explosive move higher.

First, the parameters: We’re looking for occasions when a quick selloff (the first downward-facing arrow in the charts below) was accompanied by a “death cross” — i.e., a collapse in the 50-day MA below the 200 — a messy W-shaped bottom (upward arrow), and a subsequent retest of the 200-day (the second downward arrow).

Click to Enlarge This type of setup has occurred four times in the past 17 years. In the first instance, 1994-95, the S&P bounced around a falling 200-day moving average for nearly seven months — and experienced a death cross in the process — before breaking out of a potentially ugly formation and beginning a five-year bull market.

Click to Enlarge On the next two occasions, this same series of technical events foretold the beginning of a major bear market. The next two charts show how this played out in the period from mid-1999 through the end of 2001, and again in 2007-08.

Take this with the appropriate grain of salt, since the current period is characterized by better valuations, lower interest rates and stronger corporate balance sheets than it was in either of these two cases.

Click to Enlarge This brings us to the current chart of the S&P 500. All the parameters laid out above have been met, and we might be nearing the point where we find out whether the market will experience a sustained move above its 200-day moving average or fail yet again. If the index can surmount the falling 200-day MA or at least stay within 5% to 10% of it — as it did in 1994 — the most recent volatility might prove to be just a blip in the longer-term, post-2008 uptrend. The positive trend would gain further confirmation with a breakout above the July high of 1,370. At the same time, a failure here — which would occur in conjunction with a break below the 20- and 50-day MAs — would signal increased danger of an extended downturn that could take the market back below its October low.

One additional consideration: Don’t put too much stock in Tuesday’s breakout in the S&P 500 above its 200-day until it is confirmed by a similar move in the Nasdaq 100, Mid Cap 400 and Russell 2000, all of which closed the year further from their 200-day MAs than the S&P 500.

The bottom line: Keep a close eye on the 200-day moving average as January progresses and trading volume begins to pick up again. This is likely to be one of the key technical developments in the stock market during the weeks ahead.