Bad...But Bad Enough?

10/22/08 3:00 PM EST

As of: SPX 1045 HELP  ARCHIVE

It's been a dreadful market today, with the indices hitting new intraday lows as I type.  The external indicator du jour that I showed this morning, the Euro/Yen currency cross rate, has moved almost tick-for-tick with domestic stocks and continues to trade at new October lows.

In the meantime, the pressure hasn't been as harried as what we've seen on the bad days over the past couple of weeks, and so we're not getting too many oversold types of indications.  A few of our most sensitive indicators have become stretched, but not enough to move the STEM.MR Models near their bullish (for the market) trading bands.

Breadth is horrid again today, with 5 times as many declining stocks as advancing ones.  That's bad, but volume is worse - down volume is swamping up volume by 20-to-1 on the NYSE.  That's among the worse readings we've seen intraday this month, but it was exceeded on October 6th (when the ratio hit 110-to-1!) and October 15th (when it reached 30-to-1).

The S&P is still holding above 900, a "for what it's worth" technical level I noted this morning.  I was looking for a long setup should we see some oversold readings with the S&P holding above that level, but like I mentioned above we haven't triggered too many of those extremes.  Perhaps we'll get a bounce based on that level alone and the few extremes we're seeing, but that seems like a pretty shaky trade idea to me and I certainly wouldn't stick around for long if it failed.

We're seeing a relatively loose "trend day", which has a tendency to close at or near the day's low.  It's not quite classic, though, and I'm not counting on it necessarily following through today.  Several sectors are trading in positive territory, and we saw a larger-than-usual intraday rebound off the morning low, both of which are unusual for trend days.  As we've seen several times over the past couple of weeks, the market can reverse substantially seemingly out of the blue, and I don't want to put too much weight on the trend day idea.

So I'm still basically doing nothing.  This market is trying almost everyone's patience - the shorts are awfully scared of another reversal and the longs are even more scared that we won't get one.  I've been operating under the idea that October 10th marked the low for the quarter, and am not changing that at the moment.  That means I want to try to take advantage of short-term oversold readings to get into long-side trades, but until we see a clear setup I think the penalty for being too early on only a marginal setup is too great a risk.  If we have indeed seen the low, then there should be plenty of opportunities over the next couple of months.

Euro/Yen Is The New Libor

10/22/08 9:10 AM EST

Good Wednesday morning...We begin the day with extremely heavy selling pressure in the pre-market futures.  The initial bounce after Apple's conference call yesterday afternoon wasn't able to last as Asia slumped.  A morning of not-so-great earnings releases hasn't helped and the major indices are down between 1% - 3%.

One of the fascinating things about the market, and its participants, is watching the cycle of information.  Indicators and themes that are important to some investors are totally ignored by others until it hits the front page.  Then they become obsessed with it, usually just when it's about to lose its relevance.

We've had several examples of that this year, with individual investors and bloggers suddenly watching every tick in CDSs, CDOs, SIVs, swap spreads, Libor, and who knows what else.  A couple of weeks ago, I mentioned in a "By The Numbers" snippet that Google articles containing the word "Libor" had surpassed the number with "Britney Spears" for the first time in history.  That was a pretty good tip-off that Libor was about to suffer a decline in popularity just about as devastating as Ms. Spears's.

Today's obsession is currencies.  Take your pick - Euro/Yen, Euro/Dollar, Pound/Dollar, Pound/Yen or pretty much any other combo.  The gist of the current wave of analysis is that traders are selling almost all currencies and migrating to the U.S. Dollar and the Yen.  The former is seen is a relatively safe haven with a minor role as a carry trade currency, while the latter is the carry trade poster boy.

By "carry trade", I mean that traders were selling the Yen and to a lesser extent the Dollar, and buying riskier assets elsewhere.  When risk-aversion comes home to roost, though, they sell those riskier assets and buy back the Yen and the Dollar.  As we've discussed several times over the past year, there has been a pretty tight correlation between these currency pairs and the S&P 500, shown again below.

For this chart, we're looking at the Euro/Yen, which has had a strong correlation to the S&P 500.  Bottoms in that currency pair have coincided well with bottoms in stocks here in the US, and tops in one have correlated pretty well with tops in the other.

So why the big fuss now?  Well, look at that bottom chart.  The Euro/Yen slipped to a new October low yesterday, which started to raise some eyebrows (and blood pressure levels), and today it's getting whacked anew.

The correlation isn't perfect - the S&P sold off extremely hard in June, yet we were not seeing any selling pressure in the Euro/Yen, in fact it rose substantially.  There have been a couple other periods of days or weeks where the two decoupled, but for the most part it's been a strong relationship and traders are probably justified in their worries this morning.

It's not like we've seen a huge let-up in those worries anyway.  Despite the rally last week, the latest Investor's Intelligence sentiment survey showed newsletter writers becoming even more pessimistic on the market's chances going forward.

This is quite a move into sustained bearishness from this group, which has learned to be bullish over the years.  If they're bearish and wrong, they lose subscribers, but if they're bullish and wrong they don't lose as many because almost everyone else is losing money too.  So they tend to play the risk/reward and skew to the bullish side.

Now that mentality has switched, and they're almost universally bearish (for this group, anyway).  It seems the safest bet to keep subscribers is now being bearish and preserving capital instead of trying to pick a bottom.  That's fine, but it's just that their history of previous such changes of heart haven't been all that well-timed as you can see from the little green arrows on the chart.

The thing that's most worrying at the moment is the "where does it end?" problem.  We saw a wave of concern over brokers failing, and now that's passed.  Then it was the banks, and that's passed.  Then it was money markets, and that's passed.  Now it seems to be entire countries, and it can't get much bigger than that.

The cost to protect against the default of several Eastern European countries has skyrocketed, causing a sense of panic that there will be a mass of defaults on sovereign debt, akin to Russia's debacle in 1998.  At least the cost to protect against a default on the G10 countries is holding relatively steady, and still below the October highs.  The U.S. now has the second-lowest cost out of the ten countries (that's a good thing), slightly higher than Germany.

Many, myself included, were hoping that we could get past some of these macro concerns and start to trade more "normally" based off economic and earnings releases.  That's probably a double-edged sword, though, because the economic releases stink and the market hasn't responded all that well to earnings.  Yesterday, 56% of the companies reporting earnings showed a positive surprise (above analyst estimates), but only 22% of them managed to close in positive territory on the day.

Based on the sheer number of extremes we've witnessed over the past couple of weeks, and the consistent behavior of traders after other similar fiascos, my thought has been that October 10th would likely be the low for the fourth quarter, with decent gains heading into the end of the year.

The initial reaction off that low was good, though the retracement after that was significantly deeper than I thought was likely.  Still, we've managed to consolidate pretty well, and I haven't seen a need to change that outlook.  I still want to buy into short-term oversold conditions (which we're still not seeing yet), but have no desire to chase higher prices.  The market has not at all proven that there are willing buyers at higher prices, and that's not something I want to fight.  For now, I'm sitting and waiting on a trading basis and looking for some signs of oversold conditions, particularly among our shortest-term indicators.  As far as technical levels go, they don't mean a whole lot in the current environment, but I'd be more confident in trying to buy if the S&P 500 holds above 900ish.