Another Trend Day Takes Hold

10/15/08 4:25 PM EST

As of: SPX 1045 HELP  ARCHIVE

Heading into Friday's session, we went over some data that suggested any further selling pressure on that day should be "it"...that we'd most likely see a short- and intermediate-term rebound from Friday's depths.

By Monday, it looked like we should adjust our short-term rebound expectations upward, looking for even a 25% gain in short order.  That was met quickly, as the S&P and most other senior indices showed gains nearly that large heading into Tuesday morning.

At that time, our most sensitive indicators had cycled into overbought territory, which was really the first test of this nascent bottoming process.  Strong markets that are coming out of intermediate-term oversold conditions tend to roll right over short-term overbought conditions, not roll over and head towards new lows.  Given the severity of the crash, and the magnitude of the subsequent two-and-a-half-day rally, I thought it most likely that the market would at least hang in there, not giving back any more than a few percent at most before another upthrust.

That was clearly a wrong expectation, as the selling pressure today was relentless and vicious.  The point losses were once again staggering, and few issues were spared.  Early this afternoon we went over the fact that we were seeing all the signs of yet another trend day, making it most likely we'd close at or near the day's low, and once again that played out.

Out of all issues traded on the NYSE today, fewer than 12% managed to cling to gains, including just 5 of the entire S&P 500 universe.  Down volume swamped up volume by nearly a 40-to-1 ratio, one of the most extreme cases of urgent selling pressure we've seeing during the whole debacle.

This morning we looked at a handful of credit market indicators that have been pretty good reflections of what's going on in that market.  Unfortunately, there was little improvement in them and by this afternoon most of them got even worse.  This is not what bulls were hoping to see after the weekend's news from the G7.

Not that there are all that many bulls left.  As we went over this morning, the percentage of optimists in the Investor's Intelligence sentiment survey has dropped to a 20-year low.  At the same time, though, "smart money" traders in S&P 100 options are showing one of their most bullish positions in more than 13 years, according to the configuration of outstanding put versus call contracts.  So at least we have that.

Coming into today, I was thinking that at worst we'd see the S&P drop to the 950ish area before a possible bounce, hopefully with our shortest-term guides giving oversold signals at the time.  They weren't, and the index didn't manage much more than a feeble slowdown in the selling pressure before getting hit again.  The "last ditch" support around 920 was even less effective, and now we're sitting near 900, a nice round number and about equal to Friday's close.  An inability to hold here will have everyone expecting a full retest of Friday's intraday low.

After the S&P reached its approximately 25% surge from Friday's low, I was relatively sanguine about its prospects for holding together and forming what would ultimately look like a V-shaped bottom over time.  That was wrong, and the best hope at this point is that buying interest will come in somewhere around here and help lend some support ahead of Friday's lows.  I still continue to believe that due to everything we've discussed over the past several weeks, we have seen the brunt of the selling pressure and we should see decent gains during the fourth quarter, so I'm still looking at behavior like this as opportunities to set up long trades.  Probably the best risk/reward setup at this point would be a gap down below 900 tomorrow that then recovers back above, with risk all the way down to Friday's intraday low.

Have a good evening and we'll see you tomorrow.

Rolling Over Yet Again

10/15/08 1:35 PM EST

As of: SPX 1045 HELP  ARCHIVE

Over the past two months, we've probably seen more "trend" days than in the prior ten years.  Once the ball gets rolling in one direction from the open, it just keeps going.

Today's turn is to the downside, and we're once again seeing all the hallmark signs of a trend day - all major sectors are down, breadth is horrid (only 11% of stocks are up on the day), selling pressure comes in every time the NYSE TICK manages to scramble above the zero line taking us to new intraday lows each time, and big negative extremes in the TICK are not leading to much of a bounce.

When these conditions persist so far into the day, we most often end up closing at or near the day's low - particularly when we gap down at the open like we did today.

This is obviously not the kind of behavior I'd prefer to see to help reinforce the idea that Friday marked a meaningful selling exhaustion.  Our short-term guides had reached excessively overbought territory by Monday afternoon's trading, and a healthy (or at least recovering) market would usually be able to hold its gains and even make further strides in spite of those overbought conditions.  Instead, we've just rolled over like almost every other time during the past year.

Most traders, myself included, look for the indices to retrace no more than 50% - 62% of its previous rally when coming off a potential low like Friday.  Given everything we'd discussed over the past several days, my take was that we'd be in for more of a V-shaped recovery and I did not expect a full re-test of last week's low.  A loss of more than 50% of the gains over the past couple of days would have me seriously questioning that.

Here we are, with the S&P below that 50% retracement area and on its way to testing the 62% level (around 920).  That was also the approximate high of Friday's session and at the moment it's looking like a last-ditch support area on this decline.  If we blow through that, then I wouldn't have much reason to expect anything other than an approach towards Friday's low.

Our most sensitive indicators have been busy cycling out of their overbought conditions, but are not giving any oversold signals yet.  Most of them are constructed so that it's more difficult to become oversold during bad market environments (to help avoid continually trying to buy into a poor market), so it's going to take more time and/or more of a decline before they reach oversold again.  The credit indicators we took a look at this morning are also not improving, in fact they are getting appreciably worse.

Probably the best bet from a risk/reward perspective for a trade at this point is to see a further drop into tomorrow morning that gives us at least a few oversold indications, with the S&P ideally holding above 920ish.  If we would happen to see that, then my plan would be to try again for a long-side trade.  I think there will be plenty of good long-side opportunities over the next couple of months, so it shouldn't be necessary to try to force things too much here, particularly given the extreme volatility.

Credit Improving A Bit, Sentiment Isn't Really

10/15/08 9:10 AM EST

Good Wednesday morning...We begin the day with steady selling pressure in the pre-market futures.  Despite some not-so-bad earnings reports, economic data continues to point to an exceptionally weak environment.  Foreign markets saw mostly heavy selling pressure, with indices down 3% - 5%.

One of the "smart money" gauges we follow is the trading in S&P 100 (OEX) index options.  These contracts used to be the go-to contracts for large traders, but they have since been supplanted by S&P 500 options.  OEX options now garner just a sliver of total option activity, but they have still been useful to watch.

A relatively pure way to look at the data is via the ratio of total outstanding put contracts to call contracts.  This Put/Call Open Interest Ratio doesn't make it to an extreme very often, but when it does it has given good heads-up of looming inflection points in the market.

As of yesterday's close, the ratio dropped to 0.55, meaning that there were nearly half as many puts outstanding as calls, suggesting that OEX traders are looking for the market to rally over the coming month(s).  That is a level that has been eclipsed only one time since 1995, on July 19, 2002 - a few days before a bear-market low.  The days immediately following the 9/11 tragedy were the only other time it even neared this kind of extreme.

We also compute something called the OEX Determination Index, which looks at how aggressive those traders have been when opening new put and call positions.  The lower the ratio, the less determined they are to have downside exposure via put options.

Currently, that indicator is scraping along at one of its lowest levels in years.  Over the past decade, the average three-month return in the S&P 500 when the Determination Index dropped under 0.30 has been +8.4% with 84% of instances showing a positive return.

At the other end of the extreme, we have public opinion.  The latest poll from Investor's Intelligence shows that among the newsletter writers it monitors, barely 22% are optimistic on the market's chances for gains going forward.

This is among the very lowest of readings since the survey began nearly 40 years ago.  It's even more notable when we take into account that prior to the late 1980's, fewer newsletters were polled, and so the results were much more volatile than they have been since.  The current reading is the lowest since November 1988 and is in the bottom 0.8% of all readings since 1969.

A little disturbing is the latest poll from Ticker Sense, which showed that not one of the blogs participating in that survey are bearish.  The weekly results in that poll can be very volatile, and the latest survey was taken during the heat of Monday's rally, so I'm not sure how much weight to place on it.  Still, it does have a decent enough record as a contrary indicator to raise my eyebrows a bit as it counters the more-stable readings from Investor's Intelligence and some of the other established surveys.

With the government actions taken over the past few days, mostly centered on getting the credit markets moving again, let's take a look at a few related indicators we've been watching over the past couple of weeks - the components of the Panic Button indicator of credit stress:

Surprisingly, there hasn't been much of a change.  We're still seeing short-term Treasury Bills yielding next to nothing, a sign of demand for the safest of assets.  Overnight Libor rates have come down substantially, a positive sign (though three-month rates remain elevated).  Closed-end bond funds like HYG and LQD have rebounded, but after their remarkable crash they have a long way to go to indicate that fears of huge corporate defaults has subsided.  That's also reflected in the price of protecting against those defaults, which has started to come down, but is still in record territory.

At least that cost of protection has eased significantly in some of the largest banks, as the chart below shows.

The cost of protecting against a default in some of the firms that the Treasury is invested in has dropped to new multi-month lows, a positive step, but we need to see that spread to other firms that don't necessarily have the government's backing.

Over the past few days, we've been looking at some past crash scenarios and the most likely path going forward.  Most everyone else has also been trying to compare our current crash to those past, to try to determine the likelihood of some kind of re-test of Friday's bottom (assuming, of course, that Friday did indeed mark an important low).

On Friday, I mentioned that I would be looking for more of a V-shaped recovery, and on Monday noted that a 25%+ gain off Friday's low was a distinct possibility.  We hit that approximate target yesterday morning, and ended up selling off during the bulk of the day.

With our shortest-term guides hitting overbought levels by Monday afternoon, I had wanted to see the markets hold their gains well, or even continue to make headway.  That's a sign of buying demand that we almost always get at intermediate-term lows, and something that has been lacking since last October.  Yesterday's selling pressure was mild compared to the gains from Monday, but we're still not seeing that "I gotta get in" mentality that has marked so many previous lows.

I have not been counting on a re-test of Friday's lows, and would be concerned if we retrace more than about 50% of the rally from Friday's lows to yesterday's high.  I continue to believe that we're in store for decent gains during the fourth quarter, and have more of an interest in looking for more buying opportunities than I do spots to sell.  We should get one of those within the next week or so as some of these short-term guides settle down and perhaps even cycle into oversold.