Short-term Edges Pointing Higher (But They Were Yesterday, Too...)

12/24/08 9:15 AM EST

Good Christmas Eve morning...we begin the day with another morning of muted action in the pre-market futures, as the flurry of economic releases was not enough to trigger any major moves.  Other than a big drop in Oil, most other markets are similarly lazy, and it should only get worse as the day wears on and the few remaining traders finally hang up their hat on the day, and quite possibly the rest of the year.

Since it's a day before the Christmas holiday, it's been one heck of a week, volume is going to be exceptionally low, the market has not been following through well at all the past couple of days, and most of you aren't even reading this, today's note is going to be short and sweet.

Mostly, I want to touch on something that I prepare each day to help me determine how I want to trade over the next one to three sessions.  I don't think I've shared it before, even though I do discuss most of the components when there is something particularly interesting or noteworthy.

I prepare a table of the short-term edges that I've found to be consistent short-term predictors.  Usually they reference something to do with sentiment, breadth or price action, with an occasional technical indicator when appropriate (almost always either a moving average or Relative Strength Index), and sometimes a sector or inter-market "tell" (such as whether the BKX Banking Index was up or down, or whether bond yields rose or fell).  These are the same things we've discussed in the comments regularly over the past 6+ years.

At the end of the table, I average all the edges up to come up with an overall probability of whether the next one to three days should trade higher or lower (it's mostly concentrated on one day forward, but some studies need a bit more leeway).  It also shows the number of times the study has triggered in the past.

Lastly, it calculates a weighted probability that combines both the percentage of time positive and the number of occurrences.  That way, if we have a study that shows a 100% probability of the market trading higher, but it has only triggered a couple of times historically, then it doesn't carry much weight in the overall scheme of things.

The table expands and contracts depending on the number and type of studies that trigger on any given day.  Some days there might be three of four, some days there might be a couple of dozen.  Because of that variety, the overall probability has not been backtested, since the studies included in the table are not fixed.  For testing purposes, it uses the S&P 500 futures continuous contract as computed by Bloomberg.

Going forward, look for these edges to appear in the Signpost section of the site, which up to this point I have been lax in updating.  They will also be linked in some form to the "Signal Strength" icons, which I have been similarly lax in changing (my apologies on both counts).

Here is the table:

When we've become this oversold in the past, the market has a strong habit of reverting to the upside.  It's rare to see five down days in a row during a bear market (21 occurrences), and even more so during December (1 occurrence).  There is a strong tendency to see a mid-week reversal after Friday, Monday and Tuesday have been down (73% of the time), and also after three straight 1% losses during a bear market (71% of the time).

One knock against a short-term rally is the Equity-only Put/Call Ratio, which has been exceptionally low and is now outside of its bearish (for the market) trading band.  Volume has been low, but still this has not been a good sign for the market.

We can see from the table that there is an overall positive bias for today.  Yesterday there was as well, but we could not get any upside momentum going after the first hour of trading.

From a more intermediate-term standpoint, on Monday we looked at a measure of breadth, which is currently overbought.  Historically, overbought readings during a bear market are good selling opportunities, but as we've discussed a few times lately, extremely overbought readings tend to lead to rising prices, not falling ones.  Combined with other intermediate-term positives (like here and here and here), things still seem to look OK on a one- to three-month time frame.

A move back under 850 on the S&P would have me back-pedaling on the "longer-term rally" idea, and a break of 820 will see me all but abandon it.  What we need to see is a sustained move over 920 to confirm the higher high / higher low pattern that is still valid.

For those observing, have a very safe and very Merry Christmas...and for those who aren't, a most well-deserved break from the most difficult market environment in history.

All the best,