Category Archives: Price Action

17 Gaps And What Do You Get?

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Last week, the S&P 500 futures gapped open by more than +1% and didn’t fill that gap during the day.  This means that the S&P didn’t reverse enough to kiss the previous day’s close.

That might feel familiar.  It was the 17th time in the past 3 months that we’d seen a +/- 1% gap open that didn’t fill during the day.

This is a rare historical feat.  Since 1982, it has happened only five other times.  The most recent ones are shown below.

As is pretty obvious from the chart, all of them occurred while the market was forming a major bottom.

From 1982 – 1998, the only other time that even remotely equaled this was January 1988, with 18 such unfilled gaps during a 3-month span.  Again, that proved to be a major market bottom.

So other than our current situation, there were five times that the S&P saw a large number of unfilled gaps in a 3-month span.

All five marked major market bottoms.

Hmm…

Copper Falls Into A Bear Market

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A popular topic lately has been the fact that copper has fallen into bear market territory.  At least, that’s true if you subscribe to the idea that a bear market equates to a 20% fall from a recent high.

Since copper is used in so many industrial applications, then many believe that a dramatic fall in copper prices reflects an economic slowdown, and by extension a likely future decline in stock prices.

We’ve discussed “Dr. Copper” several times in the past, and the correlation between extremes in copper prices and future returns in stock prices is poor.  It’s just not usually a very good predictor.

But let’s go back over the past 25 years for which futures prices are available and look at how the S&P 500 fared after other times copper fell rapidly into a bear market.  By this, we’re looking for a decline of 20% or more within a two-month period, when its highest point was very near a 52-week high.

Out of the 6 instances, only 1 led to an imminent and dramatic fall in stock prices.  The occurrence in November 2007 did ultimately lead to a bear market in stocks, though the S&P rallied fairly strongly for a month or so beforehand.

The other occurrences were not so bearish.  In fact, they were outright bullish for the S&P.  By six months later, the index was up by more than +12% each time.  For whatever reason, perhaps this latest bear market in copper will be more predictive of a future failure in stocks…but its history has not been consistent.

Below are charts of each of the occurrences noted above (click for larger view).

Nasdaq Corrections Greater Than 8%

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I read somewhere on Monday (sorry, I can’t remember the source) which stated that most “healthy” corrections in the Nasdaq Composite are limited to 8%.  If it corrects more than that, then it is highly likely to continue to correct another 5% – 15% before putting in any kind of meaningful low.

That just begs to be tested, because today it violated that threshold.

We’re using the Nasdaq Composite here instead of the Nasdaq 100, because of its broader base and longer history, dating back to 1971.

What we’re going to look for is any time the Composite hit a 52-week high sometime in the past 2 months.  Then it corrected more than 8% from that high.

We’ll see how long it took – and how much more in losses – before the Composite put in an intermediate-term low.  “Intermediate-term low” in this case is a day whose close was not violated for at least the next three months.

It turns out that the “5% – 15%” range was pretty accurate.  The median amount that the Composite lost, in addition to the 8% it had already shed, was -7.2% before it put in a low.

Of the 28 precedents, 9 led to additional losses of -10% or more and 16 led to losses greater than -5%.  Of those, it took a median of 42 trading days (about two months) before the index formed a meaningful low.

Of course, that means that 12 of them, or 43% of the total, had losses of less than -5% before putting in a low.  6 of those bottomed the very day the correction exceeded 8%, but on average they took 13 trading days before bottoming.

So is it a bad sign that the Composite has exceeded a correction of 8%?  On average, yes, it probably is.  But the variation among the precedents is very high, and as noted nearly half of the instances suffered additional losses of less than -5% before bottoming.

If the Composite closed below its March low of 2616 for multiple sessions, that would be a much worse sign.

Why The First IPO “Double” In Five Years May Not Be A Great Sign

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Yesterday for subscribers we touched on a few things to watch for related to the IPO market.  One of them was the performance of LinkedIn after its offering, and it’s fair to say that the public had no problems with the initial valuation.

The stock more than doubled from its offering price, which is the first time we’ve seen that from a domestic IPO since Chipotle.  This kind of thing can really affect the sentiment of the market, especially given some of the recent signs of low bullish opinion (form AAII and Investor’s Intelligence).

Based on this research paper from Professor Jay Ritter at the U of Florida (hat tip to Barry Ritholtz), we can go back to 1975 and look at other times a domestic IPO doubled from its offering price on the first day of trading.

What we’re looking for are IPO “doubles” that can really pack a punch.

So we’re only going to include IPOs that were about a year or more from the prior double.  This is to make sure that there was some shock value, as opposed to something that investors had grown used to.

The charts below show the S&P 500, along with these IPOs (the red dots).  The time frame includes three months prior to the IPO and nine months afterward.

The years 1998 – 2000 were just ridiculous with the number of doubles, so they had less shock value and weren’t included in the charts above.  ADRs were not included in the list, and from what I can determine it has only been ADRs (all Chinese stocks) that have doubled since Chipotle.

Something that stuck out right away, and which isn’t evident from the charts above, is that every single one of these IPOs occurred after the market had already staged major rallies in the months and years prior.  Investment bankers won’t unload these unless there’s demand.

Out of the 10 examples, there were 3 times that the S&P just kept chugging right along (1992, 1994 and 1997).

The other 7 times, the S&P found some trouble during the next 6 months or so.  Not necessarily major declines – there weren’t any of those – but very choppy conditions, or short-term gains that ended up being erased.

I’m not sure what, if anything, we can conclude from this, but I am left with a feeling that we may be in for some increased volatility in both directions…especially if we now see a rush of other firms trying to take public money in the coming weeks.

Margin Hikes On Silver Should Dampen Open Interest, But Not Necessarily Prices

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There has been intense interest from traders, regulators and politicians related to the performance in some commodities, particularly silver.  In response, the margin requirements to hold some futures contracts, again particularly silver, have been increased.

Exchanges supposedly set their margin requirements using computer algorithms based on historical and implied volatility, but the fact of the matter is that the ultimate decision is discretionary…and they are not immune to political pressure.

The question now isn’t whether margin requirements on silver are going up – they already have, astronomically – the question is what impact it will have going forward.

What kind of dent in sentiment does such a hike tend to have?

Unfortunately, getting historical margin requirements has proved to be exceptionally difficult.  I have about 10 years’ worth for most commodities, but only 7 for silver.  It’s not for lacking of trying, or expense.

Assimilating all the research, the conclusion boils down to this:

Margin increases tend to greatly lower trading volumes and open interest, and they stabilize price action to where it was before the event that triggered the margin change.  That holds especially true in markets like silver where speculators are a larger influence.

None of the studies suggested that price action itself was consistently impacted by margin changes.  It was only trading volume and open interest that were influenced in statistically significant way.

The chart below shows silver futures, along with the initial margin requirement for speculators, which obviously has gone parabolic.  Aggregate open interest has, true to historical precedent, fallen during that time.

One potential difference this time is that the studies are based on the idea that speculators in silver futures are “jump on the bandwagon” types.  But based on data from the CFTC, we’re not seeing that this time.  Large speculators are not that net long the futures, and didn’t ramp up their exposure as it rose (possibly due to the introduction of exchange-traded funds that are easier and more liquid than futures).

The ETFs may throw a wrench into what the exchanges are trying to do, but historically these margin hikes have led to lower volume and lower volatility.  For those who are suggesting that it necessarily means a decline in silver, they may have a point…but it’s not supported by any empirical research that I can find.  Silver prices will fluctuate based on their own merit, and not based on arbitrary margin requirements.

For those who want more detail, here are the relevant conclusions from the two most topical studies:

“In summary, there is strong evidence that (1) the exchange used margin requirements to affect market activities; (2) margins were usually raised if the trading pattern had been heavy; and (3) except for the open interest in the 1979-1980 period, changes in margin requirements were effective in stabilizing the trading pattern prevalent prior to the change.”

 - Margin Requirements and the Behavior of Silver Futures Prices, Christopher K. MA, G. Wenchi Kao and C.J. Frolich

“There is a clear causal negative margin effect on trading volume and open interest. Trading activity moves away from…the metal with the higher…margins.  [a]10 percent increase in margins is associated with a drop in average trading volume of 1.38 percent, a drop in average open interest of 1.51 percent, and a drop in the growth rate of open interest of 2.96 percent.”

 - Margin Requirements, Price Fluctuations, and Market Participation in Metal Futures, Journal of Money, Credit & Banking, Gikas Hardouvelis and Dongcheol Kim

Hardouvelis and Kim (1995) examine metals futures contracts. They exclude silver contracts during the Hunt Brothers squeeze period arguing that the special circumstances of the period would contaminate their sample.

They found strong evidence that high metals futures margins reduce contract open interest, but no evidence that higher margins attenuate contract price volatility.  Indeed their evidence suggests that any empirical margin-volatility relationship in the data owes to the prudential activities of the futures clearinghouses. Higher volatility leads the clearinghouse to increase margins, but the increase in margin has no measurable effect on contract price volatility subsequently.