The Second Wave

10/28/08 4:10 PM EST

As of: SPX 1045 HELP  ARCHIVE

Earlier today we showed a couple of charts, related to how historically oversold the market had become on both a short- and intermediate-term time frame, as well as the absolute dearth of confidence among American consumers (they are reprinted below).

Both are intriguing pieces of evidence that we should be bottoming here.  The problem is that we've already seen similarly intriguing pieces of evidence many times over the past several weeks, especially leading up to October 10th.

In the meantime, we have not been able to hold anything more than one-day rallies, and the jury is still out on this one too.  But the sheer magnitude of today's jump is impressive (the 2nd-largest gain in the S&P 500 since 1950).  Not only that, it comes close on the heels of another huge up day from the middle of this month.

We don't have enough history for the S&P to find any precedents for this.  But it has happened twice on the Dow Jones Industrial Average:

The instance in 1929 marked the "all clear", at least for the next five months.  The Dow never really looked back after its second huge rally.

In 1932, it wasn't quite as smooth sailing.  The index did tack on another 13% over the next couple of weeks before retreating to test the low.  It then enjoyed another large multi-week rally before the resumption of the bear market.

From what I'm seeing so far, today's performance is exactly the type of activity I've been waiting to see, and it should be the final stage of the fourth-quarter bottoming process.  Ideally, we'll see some additional short-term follow-through from this point, then a one- to three-day pullback.  At that point, we should have the best-looking long-side setup that we've seen in months.

There will be some things to nit-pick about today's session, and no doubt we'll hear all about them - volume is too low, breadth isn't as good as it should be, it's only month-end window dressing, etc.  But coming after the types of readings we've witnessed over the past several weeks, I think we have a good shot at turning the tide from this point, and I will be more aggressively pursuing long-side trades.

A Vote Of No Confidence

10/28/08 11:10 AM EST

As of: SPX 1045 HELP  ARCHIVE

This morning I mentioned that we need to beware these big gaps up - two out of the three other times we've seen it since September, the market closed appreciably below the open.

The one positive instance showed only a marginal pullback after the gap open, and formed a low during the first hour of trading.  That's something I was watching for today, too, but we've already sliced right through the low formed after the initial pullback from the open.  That doesn't mean we close at the lows today, but it dismisses the chance we would see a trend day higher like we did on the 13th.

The problem today seems to be two of the remaining brokers, Morgan Stanley and Goldman Sachs.  The former dropped nearly 20% earlier today, the later 10%.  The rumor du jour is that one or both were caught on the wrong side of a major move in Volkswagen, for what that's worth.  What's most important is that rumors are still in control of this market, and confidence is nonexistent.

Proof of that is shown below, the latest findings from the two major economic sentiment surveys.

The plunge in Consumer Confidence is getting a lot of attention, but it might pay to step back and see what that has meant before.  The previous troughs in Confidence were in December 1974 (43.2), May 1980 (50.1), October 1982 (54.3) and February 1992 (47.3).  By six months later the S&P 500 was higher every time by an average of +21.1%.

On the other hand, Confidence reached its all-time high in May 2000 (144.7), and October 1968 (142.3) prior to that.  You wouldn't have exactly been happy holding stocks after those instances...after a year, the S&P was down both times by an average of -8.8%.

Consumer Confidence had plunged a couple of months ago, too, dropping to 50 in June.  Other than two months of choppy trading, it was not a good buy signal, but it's at least notable that this is a new all-time low, and previous depths of despair have proven to be good long-term opportunities.

As I noted this morning, I have basically stopped position-trading this market, and am holding only a very minor intermediate-term position that I will have to jettison if we cannot hold above the recent lows.  The last thing I want to do is sell into declining prices, but a failure here will usher in a truly unprecedented era and I simply won't know what to expect.  If we would happen to see a violation and then reversal back above the lows today or within the next few sessions, then I would look to re-enter based on everything we've discussed over the past few weeks.  As for today, anything goes - I would not be surprised to see a day with a gain or loss of 5% or more, and I'm staying out as the moves seem entirely random to me.

More Gaps Than A Picket Fence

10/28/08 8:30 AM EST

Good Tuesday morning...We begin the day with major buying in the pre-market futures, with the senior indices up 4% or more.  With a 50+ point range in the S&P 500 overnight, we continue to be reminded that only a handful of centenarian traders have lived through volatility on a scale comparable to this.

The S&P 500 futures have lost about 60 points combined in the last 45 minutes of trading on Friday and Monday, a loss of about 7% in an hour and a half of market time.  That kind of late-day liquidation reminds me of the way Janus portfolio managers used to trade its mutual funds in 2002 - they had an exceptionally poor reputation on Wall Street for just dumping shares en masse without regard to price.  I suspect the poor closes we've seen is due more to mutual fund redemption selling than hedge funds or anyone else.

Over the past week, I've shied away from showing many "oversold" kinds of indicators.  Those reached a crescendo in the week leading up to October 10th, and since then it's just more of the same.  No sense in kicking the horse when it's already been put down.

Going through some of the figures from yesterday, though, I can't resist mentioning just one more.  Over the past several sessions, "up" volume has been absolutely swamped by "down" volume, enough so that the Up Volume Ratio has averaged less than 15% over the past week.

That's exceptionally poor - the lowest reading in the past 30 years - but what's even more remarkable is that the long-term average that we track, the 21-day average, also moved into one of its most-oversold conditions in four decades.

It's extraordinarily rare to see both a short-term average and a long-term average of one of our indicators reach historically oversold readings on the same day.  To the current degree, in fact, it has only happened once - May 25, 1970.

The day after that, the S&P 500 lost another 1.4%...then embarked on a new bull market, gaining 8% over the next month and 14% over the next three.

There was a day about a month earlier (April 28th) that came close to these extremes, but the five-day average didn't quite dip low enough.  Over the past 20 years, the only day that comes even remotely close to these levels was October 9, 2002 (the previous bear market low), when the five-day averaged reached 0.27 and the one-month average dropped to 0.35, well above our current depths.

While the pre-market action looks good today, it's important to remember that the S&P has gapped up more than 3% three other times since September, and the move from the open to the close was -2.0%, +7.9% and -4.6%.  The positive day was October 13th, and I think that provides a decent template for today - if this is going to turn out to be a good day, then we should form the intraday low within the first hour of trading.  If we go on to hit a higher intraday high after that, then we should close at or near the day's high.  If we violate that first-hour low later in the day, then all bets are off.

I could spend some time going over various stats, such as how the market usually reacts after a bad Monday, or end-of-month / beginning-of-month seasonality, or after five straight gap down opens...all of which would suggest higher prices in the short-term.

To be brutally honest, I don't think any of those mean squat at the moment.

Hopefully we will soon return to an environment where we can get back to the same style of probability-based sentiment, breadth and price analysis that we've done over the past seven years.  It has worked well in the past, and will work again in the future.

For now, though, the market is not trading off those behaviors, and trying to pretend that it is would be akin to hopping on the back of a man-eating Alaskan Grizzly and asking politely for it to give you a ride home.  Not a good idea (rent that great movie The Edge - a lot of apt analogies about billionaires and bears).

These unprecedented swings can create fabulous opportunities for daytraders, and there is no doubt that more than a handful are making their best money in years, possibly ever.  Of course, there are some on the other side as well, but even more in jeopardy are those trying to hold for more than a day.

When risk and volatility become so out of whack, especially with seemingly no rhyme or reason, I wind down my position-trading activity, and haven't placed such a trade in nearly two weeks.  I'm 10% long in intermediate-term positions, and don't see that changing imminently unless we move to new lows, in which case I would have to stop out because we would be in uncharted waters (literally).  If we are still in a bottoming process for a fourth-quarter rally, then there will be plenty of more opportune times to establish better risk/reward positions than now.

The focus this week will be on the FOMC announcement tomorrow, then GDP on Thursday.  The probabilities can change quickly, but at the moment the Fed Funds futures market is pricing in a 66% chance of a 50bps drop in rates, and a 34% chance of a 75bps cut (which would mark the lowest target rate in history).  When we get this close to a meeting, the futures market has a better record at predicting the FOMC's decision than any economist does, so if we don't get at least a 50bps snip, then I suspect we will be setting new lows in the indices.

I mentioned yesterday that based on everything we've discussed over the past couple of weeks, I'm optimistic that these lows will hold in the short-term.  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.  We never really got another washout-type of session that many were looking for, which should help a rally's prospects if we can hold up this morning since buyers will be trying to rush in and salvage one of their worst months on record.