Snapshot Notes - January 22, 2008

The indices have held up very well today, mostly closing the gaping holes left from the close of trading last week.

It has been a very impressive bounce, going further than I thought it would, but still about in line with the other times the Fed has surprised the markets with an unscheduled rate cut.

The reversal today has brought up some comparisons to the low last August, and there may be some validity to that. In the table below, we highlight some of the stats and studies we discussed then, and whether we're seeing comparable readings now:

STAT / STUDY	COMPARABLE?
New lows on the NYSE have expanded to 1000+, or nearly 30% of all issues, an infallible buy signal for the past 20 years	YES
A flight to safety in terms of buying interest in short-duration Treasury Bills	YES
Excessive put/call ratio readings	YES
Spike higher in implied volatility	YES
Rydex traders fleeing to "safe" funds over "risky" ones	YES
Decline was seen at or near option expiration	YES
Margin requirements being raised on some futures contracts	YES
FOMC issues surprise rate cut	YES
Stock/Bond Ratio out of whack	YES
Corporate insiders buying much more than selling	YES
Reversal day on huge volume	MAYBE
Sentiment surveys showing pessimism at multi-year extremes	SOME
Commercial hedgers heavily net long index futures contracts	NO
Flush downward in the TICK	NO
Market above support in an uptrend	NO (!)

Something we'd looked at back then was that while the probability of us being at an intermediate-term low seemed high, all the prior precedents we looked at came back down to test (but not exceed) the low of the reversal day.

We didn't really see that last August, though. The S&P 500 did suffer a two-day 45 point decline about a week after the low, but it would be something of a stretch to call that a "test". The precedents we looked at over the past couple of days, that were more geared towards crash-type situations, typically did see lower lows in the days and weeks ahead.

So there are several positive comparisons to last August's low and reversal, but the big (big!) difference is that we're not in an uptrend and holding above support, like we had seen so many times in the past few years, including August. For me, that tips the scales more towards the other crash-type studies we looked at, and those were pretty clear in that the initial crash day more often than not led to further selling pressure and new lows, after one or two more days of rallying.

The big test for any nascent recovery is how much buying pressure is seen right after the low. Big up days, with heavily skewed volume into advancing stocks, is a good tipoff that buyers have found enough value to be aggressive, and that usually continues for several weeks at least. If the market hits short-term overbought readings, and keeps right on rallying (like it did in August), that's another good sign seen at almost every intermediate-term low.

I'll be on the lookout for those types of developments in the days ahead in order to judge whether it's more likely we've seen such a low or just a severely oversold temporary snapback. Unlike the past few years, I'm not ready to bet on the idea of a lasting bottom based solely on the readings we've seen lately. If we continue to rally in the short-term, the next good setup should be on the short side, and I'd be looking for any move towards 1350-1375 as a place where sellers should come out in force.

We got the bounce off the morning lows that seemed like a pretty good probability, with the futures jumping about 4% from the morning depths.

That's about in line with past surprise Fed rate cuts. I'm not going to wax philosophical about whether they're right or wrong for doing what they did, when they did it, and to what magnitude. All I know is that when things get as bad as they are, the Fed tends to cut rates, and when they do, stocks react.

The history of surprise rate cuts shows that the Fed's impact has been effective, but temporary. Following are the recent instances of the Fed cutting rate at an unscheduled time, and the reaction in the S&P 500 fund, SPY, in the very short-term:

Only the occurrence in August of last year coincided with an intermediate-term low, which helps confirm some of the other data we went over yesterday and early this morning. Such severe declines like we've seen have resulted in short-term snapbacks every time, and only a few have turned into intermediate-term bottoms.

With such a jump from the morning lows, I've been pulling back on short-term positions from this morning. We've already satisfied the average return from buying into these things, and from here the edge becomes decidedly less decisive. I think we have an OK chance to add more to the gains over the next day or so, but I don't want to be pushing strongly on that idea, given the propensity of these things to fall back over the next several sessions.

Good Tuesday morning...Given the nature of the recent activity, I'm sending these short-term notes to all subscribers, and not just those who signed up for the intraday updates. Depending on what happens during the day, there could be several more of these notes as conditions warrant.

As we've gone over the past couple of days, it's difficult to find many comparisons to the current wreckage. The volatility, as determined by the number of 2% down days, has been on a par with past waterfall declines, as has the sheer magnitude of the price drop.

That magnitude just got a whole lot bigger, judging by yesterday's activity, with the major indices down another 4% - 5%. It could have been worse than that, but the futures markets were pushing their limit-down restrictions.

Because of a lack of good intraday data, it's nearly impossible to find any other comparisons to such gaps as this other than Black Monday and 9/11. In order to go back in history, we have to use closing prices only, which is a hindrance but can still give us some potential information on dislocations like this.

So let's look at the history of the Dow Jones Industrial Average (from 1897 - present) for any one-day 5% declines, coming on the heels of at least a 5% drop over the past month, with the day prior being at least a six-month low. That gives a pretty good description of a crash scenario.

In every case, the DJIA was higher two trading days later, by an average of +6.8%. That was skewed by the two instances in 1929, but without those two the average short-term snapback was +4.2%...still not too shabby.

Leading up to the "crash" day, the Dow had dropped an average of -15.9%, but again that was influenced by 1929. Without those two, the average was -11.7%, not far at all from our current situation. The bad news is that the average decline on the crash day was over -6%, meaning that if our current situation stayed true to history, we might have more downside to come today.

But this one-day decline is coming in the form of a gap open, which is more emotional than a decline happening during regular trading hours. Yesterday, I went over the prior two instances of such large overnight gaps in the futures markets. The only comparables were Black Monday (October 19, 1987) and right after 9/11.

I showed charts that detailed daily and intraday performance after each, with the 1987 gap resulting in even more selling pressure during the day (to put it mildly), while the 9/11 instance led to some short-term relief. For what it's worth, In both cases the markets didn't bounce unless the FOMC had announced a rate cut.

I noted yesterday that I would be looking for at least an intraday bounce, perhaps even of a couple of percent, particularly if the FOMC announces a "surprise" reduction in their interest rate target. But the history of these types of declines isn't so kind in the intermediate-term, with less than a 50/50 shot of such behavior as this morning resulting in an intermediate-term low.

I'm using the opening gap price as a kind of fulcrum for the day, preferring long-side trades above, but being more careful below. If we're seeing one of those once-in-a-lifetime declines, things could get much uglier during the day. The risk of that seems infinitely small, but it's there nonetheless.

There are two things that worry me most about trying to buy aggressively into this gap:

1. The magnitude of the gap open is being limited by the collars put on by the exchanges. Limits don't allow natural trading patterns, so the "real" balance point might be a couple of percent below where the futures are indicating.

2. One of my futures brokers (Interactive Brokers) eliminated day-trading margin on futures this morning, which basically means that short-term futures traders with them will have half the buying power they did if I.B. hadn't taken this step. Other brokers will most assuredly be taking similar steps. We also will see a wave of forced margin selling during the day today as accounts drop below their Fed- or broker-mandated equity requirements. Margin selling is often tossed out there as a cause of some declines, but as a former manager of a margin department, I've always known those arguments to be ridiculous. Except for a day like today. Whether there will be enough buying interest to absorb that forced selling, I don't know.

Again, my bottom line is that based on the emotional extremes coming into today, and most importantly the severity of the price decline and gap open, I believe we have a good chance of seeing a substantial snapback soon after the open and it probably makes sense from the long side on a smallish, speculative basis. However, if we don't bounce well or at all, and hit lower intraday lows as the morning rolls along, we could lose several more percent so it's important to keep that possibility in mind if trying to trade a snapback.

If we do get additional selling pressure during the day, I would then look to be a more aggressive buyer of that towards the close- such disasters have resulted in short-term lows every time we've seen them in the past 100 years, and I don't think this would be an exception. I would anticipate it being a short-term low, and not necessarily a great investment opportunity, at least not yet. Assuming the S&P 500 cash index would be around 1259 as I type, I'm moving the signal strength to the long side, based on the precedents we've gone over.

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