Post-Holiday Letdown

12/01/08 8:40 AM EST

Good Monday morning...we begin the day with major selling pressure in the pre-market futures as traders return and the usual post-Thanksgiving letdown begins.  Most major overseas markets are down 2% - 3% and commodities are getting hit hard.

Last week certainly was eventful, as the indices managed to string together the longest clump of up days since early July (which was not coincidentally another holiday period).

There have been five times in the history of the DJIA that it dove to a new yearly low, then managed to piece together five straight up days.  Over the next week, the index held on to its gains, or added to them, four times averaging +1.3%.

But if we're looking for some harbinger of the end of the bear market in that behavior, we're going to be disappointed.  By two weeks later, the Dow was up only one time, giving back its gains made after that initial spurt.  Even three months later, the index was higher two of the five times, and showed an average return of an uninspiring +0.3%.

It did do a fairly decent job at pinpointing two bear-market lows, but failed miserably the three other times.  For those curious, the dates were 12/30/41, 05/04/42, 07/03/62, 04/14/77 and 10/02/81.

For what it's worth, the Dow has ended November with five straight up days four other times (in 1946, 1959, 1970 and 2003).  The index followed through to the upside during December every time, averaging an additional gain of +4.8%.  December has a reputation for very strong gains, but as you can see from the seasonality section of the site, the gains tend to be mostly skewed to the back end of the month.

The streak did inspire some action in call options, as the five-day average of the Total Put/Call Ratio from the Chicago Board Options Exchange moved to its most extreme level in more than six months.  There have been three other times the average moved outside of its bearish (for the market) trading band since last October, those being early October 2007, late December 2007 and mid-May 2008.  All coincided with short- and intermediate-term peaks in the market.

Among the smallest of options traders, we saw very curious behavior last week.  Those who traded 10 contracts or less reduced their speculative call option buying to only 24% of their total option volume.  That contrasts to an almost 50% allocation near the market peak last October, and marks the lowest reading in more than five years.

From a contrary perspective, that should be a good sign of severe risk-aversion from a group of traders that tends to be wrong when they move en masse to an extreme.  But oddly enough, they also greatly pulled back on their purchases of protective put options.  Normally, when we see them stop buying calls, they start buying puts.  Not so this time.

Instead, these traders moved to a strategy of selling call options, which made up more than 40% of their total volume.  Selling calls to open is regarded as a mostly neutral strategy, and is best used when the market is about to enter a period of lower volatility with a very modest upward drift.

The quick acceptance of the rally helped to move some of our shortest-term guides, like the STEM.MR Model, to an extreme overbought condition early last week.  While some may discount the trading last week due to the holiday break and exceptionally low volume, the fact remains that the market was still able to tack on further upside after reaching an extreme overbought condition.

This is really the first time since July where we haven't seen the market fall apart almost immediately after becoming short-term overbought.  In July, when the model became overbought for a second time within a few days of the first reading, the market pulled back for several days, but then was able to rally for about a month.  That's consistent with the kind of behavior we very often see - when buying interest is so strong that we see additional gains after an initial overbought reading, it typically signals even more upside in the intermediate-term.

Last week I mentioned some data on corporate insider transactions as compiled by the excellent InsiderScore.com service.  If you check the latest update of the chart on the site, you'll see that last week insiders moved to even more of an extreme.

Last time there were some technical issues which may have explained some of the bullish readings, but in the latest report there is no such excuse.  If I may take the liberty of quoting from their weekly report once again:

"Insider sentiment once again moved to its most bullish level ever during our 279-week tracking period (dating to the week ended July 29th, 2003) and our research indicates that insiders are more bullish now than at any time since 1975.

Whereas last week there was a contributing factor which lead to our reading being slightly higher than it normally would, this past week was quite simply a stunning display of insider buying.

Our Weekly Score, which measures buying and selling, hit record levels in the Basic Materials, Services, Technology, Industrial Goods and Financial sectors, and the Healthcare and Consumer Goods sectors had their second-best showings as each both came off record highs last week."

So there are a few glimmers of hope again for that elusive intermediate-term rally, not the least of which is that by last Friday, the market had once again cycled down to an extremely oversold condition.  The Dumb Money Confidence registered a lowly 13%, the kind of level that has preceded other bear-market rallies.  Each of the other rallies has failed, and each in a more compressed time frame than the last.  The latest rally was the most wicked of them all, with no letup in the volatility that should bring more investors into the market.

I mentioned in my last comment last Monday that I would be most interested in a short position if the S&P 500 traded to 900 or so in the coming sessions, which is where it appears to be failing this morning.  From a long-trade perspective, a better opportunity would come later this week when we work off some of these latest overbought readings with the index ideally holding above 850ish.