Nearing The Endgame, Or Else

10/27/08 8:45 AM EST

Good Monday morning...We begin the new week with selling pressure in the pre-market futures once again, though they have come off significantly from the early-morning lows.  The S&P is currently indicated to open down around 20 points, which is about half the loss from a few hours ago.

The data that updated over the weekend unfortunately doesn't help clarify matters much, at least in terms of suggesting we're at/near any kind of extreme other than what we've already witnessed.

I mentioned the positioning of traders in the VIX implied volatility contract on Friday afternoon, which is kind of an iffy positive for the market at this point.  The Commitments of Traders data for the major equity indices is inconclusive - as we've gone over several times over about the past year and a half, this data has changed compared to how it used to act in the past, and is no longer reliable, especially for commercial hedgers.

The combined data for small speculators had remained relatively accurate as a contrary indicator, becoming extreme at just the right times to indicate a pending market reversal.  But beginning last summer, that too started to change and the positions went to a whole new level of extreme.  Since then, it hasn't correlated nearly as well with weekly market movements and I'm not reading a whole lot into it at this point.

The latest data on the behavior of the smallest of options traders also isn't very conclusive.  Despite the market's losses last week, they are still showing no signs of excessive fear.

They did reduce their speculative call-buying activity to about 30% of their total volume, relatively extreme when looking at the past few years - but still well above the 20% level they sunk to in 2002 and 2003.

More disturbingly, they actually decreased their protective put purchases last week.  So while they seemingly pulled back a bit on their hopes for an imminent rebound, they are showing absolutely no sign of panicking by rushing into put options like they have near past intermediate-term market lows.

Last week, I also noted that the latest AAII sentiment survey of individual investors was showing a very odd divergence - despite heavy market losses, those folks were actually becoming more bullish, not less.  And the massive outflow from equity mutual funds reversed course, with more money flowing into stock mutual funds than out for the first time in 20 weeks.  The previous net inflow was way back in early June.

Another example can be found in the Odd Lot data.  The Odd Lot Purchase Percentage (which tracks what percentage of total volume is being using to buy stock instead of sell) and Odd Lot Short Sales reached pessimistic extremes at the earlier October low, but since then they have settled back into neutral, despite continued selling pressure in the broader market.

I don't know if all of this is more a reflection of the "don't panic!" advice being espoused on TV, or the simple notion that these folks have already sold most of what they're going to sell, and simply don't care much one way or the other at this point.

I'm always leery of that latter point, but at least one piece of corroborating evidence would be that individual investors are holding one of their lowest allocations to stocks in the past 20 years, and one of their highest cash levels.  New figures come out on Thursday, and I suspect we'll be seeing even more of an extreme at that time.

It appears as though the "easy" trade in terms of extremes has passed.  On October 9th and 10th, we discussed the high likelihood that prices would rebound strongly from whatever washout occurred on the 10th.  Since that initial reaction, we've pulled back to challenge the low and in the meantime have seen some not-so-encouraging developments.  A lack of additional sentiment extremes is one, as is the poor action in traditional leading sectors like technology.

Last week the Nasdaq 100 broke its October low, and this morning we're getting the same from the S&P 500, at least in the pre-market futures.  This was something I obviously did not want to see, since it basically ushers in the idea that we're seeing selling pressure so persistent and so severe that it's on a scale unlike anything we've seen before.  It's hard to trade based off historical precedents when there are none.

Based on everything we've discussed over the past couple of weeks, I continue to have some hope (if I may be excused to use the word "hope") that these lows will hold over the next couple of days.  By that, I don't necessarily mean that we have to hold above them - it would not be atypical to see a spike under the obvious October 10th low that helps to wash away some resting sell stop orders - but any violation of the low should be reversed within a day or two.

Many analysts are looking for just such an event based on the whole "ugly Monday in October" idea, and it does appear to be a relatively high probability.  But for those not currently invested on either a trading or investment basis, based on the idea that we're kind of hanging by a thread at this point, the best risk/reward trade would not involve trying to buy into this morass and hope for a reversal, but to wait for a more stable environment and better signs that buyers are willing to stick around after more than one up day in a row.  Once we get some such confirmation, there should be plenty of more gains over the coming month(s), and with a significantly better risk/reward profile.  There are some fairly bullish short-term indicators here (consecutive 2% gaps down, Friday's closing low but not intraday low, and end-of-month seasonality), so if we're going to get a reversal the most likely day should be today.