Thrust, Then Parry, Should Ultimately Head Higher

12/11/08 9:00 AM EST

Good Thursday morning...we begin the day with some modest selling pressure in the pre-market futures as jobless claims once again surprise to the negative side.  There hasn't been much consistency in overnight trading, and the other macro tells (fixed income, currencies and commodities) are showing mixed performance.

One of the consistent behaviors of broad equity averages is the pattern of thrust-and-parry.  We see big one- or two-day moves in one direction, then one or more that consolidate that initial thrust.  Generally, though this is less consistent, the market continues in the direction of the initial thrust.

There are many ways to look at those patterns, one of which is highlighted below.  What we've seen over the past few days is a big gain in the S&P 500, then two consecutive inside days.

An "inside day" is a session where the day's high is lower than the previous day's high, and the day's low is higher than the previous day's low.  In other words, today's intraday range is smaller than yesterday's intraday range.  It shows a contraction in volatility, and a consolidation of the previous day's move.

Since the inception of the S&P 500 futures, there have been four other periods when we saw a 2% or larger gain, then two straight inside days. 

We're running into the law of small numbers again, unfortunately, which is something we've had to deal with a lot over the past couple of months as the market continues to make unusual moves.  Anyway, there was a fairly consistent pattern going forward - some short-term weakness, then a longer-lasting move in the direction of the initial thrust (i.e. up).

If we relax the parameters a bit and only require one inside day (instead of two) after a big up day, then we get 30 occurrences.  The edge wasn't huge, but showed the same basic behavior - the S&P was positive over the next couple of days 43% of the time, with an average return of -0.5%.  But from there, over the next two weeks it was up 60% of the time with an average of +0.5%.

From the year 2000 - present, it has occurred 10 times.  The S&P pulled back in the very short-term 8 of those times, averaging -1.6%.  But after the short-term shakeout, it was up 8 of the 10 times over the next two weeks, averaging +0.6% (the two failures were big, though, showing a loss of -7% and -16%).  All of them were focused during a bear market, either 2001-2002 or in 2008.

Yesterday we went over the fact that a few of our shorter-term indicators were showing new (bearish for the market) extremes, like the OEX Put/Call Ratio and Rydex Beta Chase Index.  Both have a habit of preceding some short-term weakness in the broader market.  Also, the group of short-term indicators we looked at on December 4th were close to going "all in" on the overbought side, something that has preceded short-term weakness in the market with regularity, but they're still just skirting those overbought levels and not giving any kind of real solid signal.

The move over the past couple of weeks has move more of our indicators out of their oversold areas and back to neutral.  Because several of our models adjust to the current market environment, even neutral readings can give "sell" signals during a bear market.  A perfect example of that is the Intermediate-term Indicator Score, which is now at a level that has seen the market roll over every time since mid-2007.  Every time.

So how do we reconcile all these conflicting readings?  I mean, we have some bullish studies, a few (short-term) bearish ones; some bullish indicators, some bearish ones; some bullish models, some bearish ones.  It's enough to give a guy a major headache.

My take is that several of the extremely overbought indicators we're seeing are so overbought that they are historically meaningful.  We discussed this on Monday and Tuesday with regard to breadth - when the market goes from extremely oversold to extremely overbought in a relatively short period of time, it has consistently coincided with intermediate-term market lows.  It didn't work in October, which has to be a concern, but I'm willing to give it the benefit of the doubt again, given the other positives that have been gathering over the past couple of weeks.

For the short-term, I don't have much of a clue quite frankly.  As I noted yesterday, I think we could just as easily see an extension of the rally above Monday's highs, or a complete crap-out and a move back down to 850-875.  I'd still give a (very) slight edge to the latter, but not enough to trade it.  I do continue to believe that any move into that zone would result in higher prices over the coming month(s), and am willing to try once again for that elusive intermediate-term low.