Should Be Entering Choppy Waters

10/14/08 8:55 AM EST

Good Tuesday morning...We begin the new day with more details about the bailout plan, and a major reaction in the pre-market futures.  With the news finally out, the emotional, anticipatory part of the equation is now being played out, and the more difficult period of implementation will take over.

Last week, we had ample opportunity to go over extremes, in all their various forms.  We saw things last week in terms of price behavior, breadth and sentiment that we hadn't seen in 20, 50, sometimes 100 years, if ever.

That means that we will now have a real-time, working lab of what works and what doesn't during nearly unprecedented conditions, something the current generation of traders had been lacking up until now.

I think it's fairly safe to say that despite everything thrown at the market over the past several weeks, one of the most helpful guides has been historical performance after similar crash scenarios.  Even though we haven't had a big sample size, the market has played out pretty well in line with the forecasts we've been discussing over the past few weeks.

In a nutshell, in mid-September it called for extreme volatility with a downside bias, then a violent one- to three-day rally after the crash on September 29th, followed by a test and probable violation of that low.  That should then lead to a more lasting bottom within 5 to 10 trading sessions.  Yesterday morning, we looked at a few precedents which suggested a 20% - 25% bounce from Friday's lows over about a week's time, before choppier conditions ensued.

With the move in the futures since yesterday's close, the indices certainly satisfied that latter criteria, and in a most expeditious manner.

We're seeing all kinds of tables in the media about how yesterday's gain was the largest in however many years.  They all point to the 1930's as the other time we saw such huge rallies, with the subsequent conclusion that the 1930's was a poor decade overall for stocks, and buying after the huge recoveries was almost always a mistake.

But those comparisons lack context.  So let's look at any other time in the history of the DJIA that it suffered its worst week in at least a decade, then enjoyed its largest one-day gain in at least a decade.

To help with the context, on the chart we include three indicators we looked at last week:  the percentage that the Dow has declined from its yearly high, the percentage it has moved from its 200-day moving average and its historical volatility over the past month.  The gray dotted lines on each show where we are currently for comparison's sake.

First, 1929:

This instance is probably the closest to our current circumstances in terms of the three indicators on the chart.  Obviously, buying into the rebound wasn't a great idea in the short-term - after one more day of gains, the Dow lost double-digits over the next couple of weeks before forming its intermediate-term low.

But (and this is a big "but"), as we looked at yesterday morning, in terms of price structure the last week was much more similar to the second wave lower when investors heaved their shares, as opposed to the initial panic and failed rebound.  And the action over the past two days helps to confirm that view.

In 1962, the initial rebound also wasn't the greatest time to be looking to go all in on the long side.  The Dow did manage a decent gain the next day, then fell apart and again suffered double-digits losses over the next month.  But even after that second plunge, the price-based indicators on the chart didn't get anywhere near the level of oversold that we hit last week.

Everyone's favorite analog, 1987, is fairly comparable in terms of the extremes in the trio of indicators.  Because it occurred over just a few days instead of over a year, historical volatility was much higher than our current situation but the others are fairly close (still not as extreme as they are now, though).

As we're all probably sick of hearing about by now, after the '87 crash we rallied nearly 30% over two days' time before dipping again and basically undergoing almost two months of testing the panic low.

Because the size of the "crash" in 1997 wasn't as nearly as large as what we've seen lately, it doesn't get mentioned at all.  But in terms of what stocks had experienced in the decade leading up to that point, it was every bit as scary.  Afterwards, stocks chopped around for a couple of weeks before resuming the uptrend.  Like 1962, I don't think this one is especially comparable to our current situation simply because the indicator extremes are so many magnitudes greater now.

On Friday, I mentioned that I was changing my expectations for what we should see in terms of a bear-market bounce.  Instead of the typical 5% - 15% rally over one- to three-months' time, which had proved to be a decent rule of thumb for previous rallies over the past year, I was now looking for a V-shaped bottom that led to a short-term gain of 10%-15%.  Yesterday, I thought we'd need to up that expectation to a possible 25% or greater rally, which should take us to 1025ish on the S&P over about a week's time.

We've hit that level and then some, and in a much briefer period than expected.  I don't know if that's a good thing (because it shows an incredible amount of buying power) or a bad thing (because so much buying power has already been used), so I'm going to have to key off how the market reacts.  We're already relatively overbought in the short-term, which has caused great difficulty for stocks since last October.

The market almost always gets short-term overbought when coming out of meaningful intermediate-term lows, but it's almost always able to hold well or even make further gains in spite of it, so that's one clue I'll be watching.  Due to the gap up opening, I'll also be keying off the high made during the first hour of trading (if we make higher intraday highs after the first hour, it should lead to even more gains heading into the close).  That worked exceptionally well yesterday, but I have less confidence it will be as reliable today - it's very rare to get two trend days in a row, especially after such as extreme a move as we saw yesterday.

With the back-to-back explosive gaps, my intermediate-term expectations remain in force and I see no need to adjust those.  For the short-term, though, I'm less convinced that we're going to see meaningful gains from this point.  I suspect that after the past couple of days, especially with the news finally out, we're about to enter a choppier period over the next one to two weeks before further gains into the end of the year.

On a side note, we've posted the third quarter letter to managed account clients.  It's already a bit dated, but I always get requests to read them so follow the link if curious.