Looking Better...So Far

10/30/08 4:30 PM EST

As of: SPX 1045 HELP  ARCHIVE

This morning we went over a few short-term negatives, such as the Fed Reversal pattern, an extreme in the Equity-Only Put/Call Ratio and modestly overbought intraday indicators.  The futures were also showing a large gap up opening, which tends to fade during the day, but pre-market futures have become less reliable as an indicator lately.

So far the market looks like it's passing the test, which would be a change in character from what we've been seeing since July.  When we looked at a few of the developments seen over the past couple of days, such as the exceedingly low Arms Index from yesterday and the multiple 7%+ gains in the Dow, seeing the market hold up here looks to be a very good sign.

This is the kind of behavior we've been waiting a long time to see, so it would be disappointing to have the market roll over to new lows at this point.  I'm not counting on that happening just yet - I continue to think we're in store for a fourth-quarter rally based on everything we discussed during the past few weeks - but I have stops in place just in case this unprecedented volatility continues.  I wouldn't want to see the S&P back off below 890ish if and when we get another short-term pullback, so that's what I'll be watching for most closely.

As for selling or shorting the rally attempt, that's not something I'm very keen on doing at the moment given the bullish implications in the intermediate-term.  But if we do see another push higher (particularly if it would happen to last through the seasonally positive first few days of November) and we got another round of short-term overbought readings, then I would be looking more aggressively at selling.  For the time being, my focus is more on watching for some indications that we've hit a better risk/reward scenario from the long side, which should come on the next pullback.

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

A Test Of Short-Term Negatives

10/30/08 9:10 AM EST

Good Thursday morning...We begin the day with buying pressure in the pre-market futures once again, as a large recovery in Asian markets and some not-quite-as-bad-as-feared economic data has pushed the indices up several percent.  After the gigantic drop into the close yesterday, this morning's jump is only taking us back to about where we were 10 minutes before the close yesterday.

The fact that the futures are gapping up the morning after an FOMC rate decision isn't necessarily good news.  The last three times the S&P 500 gapped up 1% or more the day after a Fed decision, it was lower two days later all three times by an average of -1.5%.  Even when it only gapped up 0.5%, the two-day return averaged -0.7% with a 25% success rate.  We've gone over this "Fed Reversal" tendency many times over the years, and it has been relatively consistent.

Of course, that's assuming we're in a normal market environment, which we most clearly are not.  Over the past four days, the S&P futures have moved a combined 160 points during the last 45 minutes of trading.  Essentially, that means that the index has moved 17% over three hours of market time.  I'm not sure what the fundamental justification would be for adjusting the market cap of the S&P by about $1.5 trillion in three hours.

Not that the futures have been a great indicator lately, either way.  Since the high last October, when the S&P has gapped down 1% or more, then it closed higher than the open 47% of the time with an average return of -0.1%.  When it gapped up 1% or more, then it closed higher than the open 52% of the time by an average of +0.2%.  No edge there.

Highlighting just how rare follow-through has been, though, when the index was up 2% or more over the past couple of days, then it gaps up 1%, the day closed higher than the open only 1 time out of 5 occurrences, with an average return of -0.8%.

On October 21st, we discussed what's happened in the past when the Equity-Only Put/Call Ratio has moved outside of its bearish (for the market) trading band, which it did again yesterday.  Since the October peak last year, whenever that's happened and then the S&P gaps up by any amount the following morning, then the index has shown a positive return 37% of the time, averaging -0.6%, through the next day's close.

None of this is terribly surprising.  We've been in a wicked downtrend for a year, so any hints of gaps open or excessive optimism have been beaten down quickly.  There's little sense in throwing out a bunch of stats that just serve to reinforce common sense.

The big test here will be whether or not we can withstand the short-term negatives (including the Fed Reversal pattern, modestly overbought short-term indicators, the tendency to retreat after a gap up opening, and the put/call data discussed above).  We've been looking for some kind of change in character, and so far have been unable to find any.  So if the indices hold up over the next day or two, then we'll have some pretty good evidence that the multitude of intermediate-term positives we've been discussing are finally taking hold.  Even if the buying pressure is "only" because of month-end buying by funds, it's still evidence that there are more eager buyers than sellers, a definite change in tone.

We do have a couple of initial indications that that should be the case.  Yesterday we went over the extremely low Arms Index number, and the day before we looked at a couple of historical precedents for multiple 7% gains in the Dow.  Both suggest that we've seen the worst of the selling pressure, and have witnessed the initial burst of buying pressure that normally comes immediately after the low.

The next step in the bottoming process is for the market to hit short-term overbought conditions (which we're arguably seeing now), and then holds up better than usual.  We have yet to see that, which is why the next day or two should be telling.  If we don't fall apart like almost every other time over the past year, then we'll have even more evidence that the next one to three months should see the best gains we've had all year.  From this point, on any retracement I'll be watching for the S&P to hold 890ish - below that, I'm going to have to assume that we're heading for new lows.