Election Day Optimism

11/04/08 8:55 AM EST

Good Tuesday morning...We begin the day with heavy buying pressure in the pre-market futures, with the major indices up at least 1.5% as I type.  The hype of today's elections will pass quickly, and focus will return to earnings and economic data, in particular the jobs report on Friday.  Recent economic releases and corporate outlooks have been dismal, so no matter who the new faces in Washington turn out to be, they have a tough row to hoe.

I don't want to spend an inordinate amount of time on market behavior surrounding elections, there is plenty already out there on this site and the web in general.  I've been asked a lot about it, though, so let's just touch on it briefly.

If we look at all elections since 1950, there was a bias of strength and optimism prior to the election results.  Buying two days before and holding through election day resulted in positive returns 86% of the time, averaging +1.0% (until 1980, the stock market was closed on election day).

But from election day to two days afterward, the S&P 500 was up only 35% of the time, though it did manage a positive overall return that averaged +0.1%.

Since the inception of the futures market, there has never been a time when we've seen a gap up on election day greater than +0.5%, so obviously we're seeing yet another unprecedented action here.

There were two times the futures gapped up less than 0.5%, in 1984 and 1988.  The market went just about straight down for six days afterward both times, losing 3.2% in 1984 and 4.0% in 1988.  Interestingly, buying after that short-term drop and holding for the intermediate-term would have worked out fabulously (gaining about +11% over three months both times).

Yesterday I mentioned a few short-term negatives, one of which was the behavior of odd lot traders (those who trade in blocks of fewer than 100 shares).  By Thursday of last week, they spent 57% of their volume buying shares instead of selling, enough to be considered excessively optimistic.  On Friday, that percentage shot up to 62%, the highest we've seen in years (in contrast, at the low in October the percentage was only 42%, one of the lowest in years).

It isn't just odd lot traders, though - in the Rydex family of mutual funds, those traders have concentrated on trading the riskiest funds at a pace that's five times greater than the "safe" funds, according to the Rydex Beta Chase Index.  Just last Monday, that ratio was nearly reversed, as they were piling into the safe funds at a four-to-one clip over the risky funds.

These kinds of readings have left our Short-Term Indicator Score in overbought territory for two straight days.  Since 2000, there have been 21 times when the Score was overbought for two days, then the S&P gapped up at least +0.5% the next morning.  Buying that open and holding for three days resulted in only 4 winning trades (a 19% success rate) with an average return of -1.1%.

We have clearly seen a change in character over the past week, with the multiple buying thrusts, low Arms Index, and the ability to hold in positive territory for several sessions after last Tuesday's major up day, so we keep getting confirmation that October 10th marked an intermediate-term low and we should see further gains during the fourth quarter.  It's expected that a market that is emerging from severe oversold conditions pays no attention to short-term overbought conditions, which is a sign we've been looking for in vain for months.  Every time we've hit overbought conditions since August, we've rolled right over and usually hit new lows.  Not this time, which is a major change.

For the meantime, we continue to have some of those short-term negatives, and I'm leery about our prospects here.  Especially with the S&P 500 under 1025ish, I don't think we're going to be able to sustained these gains when looking out several sessions.