Snapshot Notes - February 19, 2009

Good Thursday morning...We begin the day with some buying interest in the pre-market futures. We witnessed a nasty drop after the close of regular trading hours yesterday as Hewlett-Packard disappointed a few folks, and traders have been consistently bidding the futures higher since then.

On Tuesday, we looked at one measure of individual-investor sentiment, that being the amount of speculative call buying by the smallest of options traders. It was not exactly encouraging, as they were busy buying the dip last week. That indicator has a good contrary track record, so seeing them become more bullish during such a large down week wasn't a good sign.

Put/call ratios have ticked up so far this week, and I suspect we'll see a different story when the more-detailed weekly numbers come out over the weekend. And there's another bit of good news - according to the latest survey from the American Association of Individual Investors, their membership's bullishness has waned considerably.

The percentage of AAII members looking for a market rally has dived from 49% at the beginning of the year to 22% as of the latest reading, with responses included through Wednesday afternoon.

The table below shows the future performance in the S&P 500 since the survey's inception in 1987 when the percentage of bulls dropped to 22% or below.

S&P 500 Performance After AAII Bull Ratio <= 22%
	1 Month Later	3 Months Later	6 Months Later	12 Months Later
Avg Return	+2.1%	+5.3%	+9.1%	+16.7%
% Positive	77%	95%	89%	94%
Any Random Time...
Avg Return	+0.4%	+1.4%	+3.5%	+8.5%
% Positive	60%	65%	71%	77%

Over the next three months, the S&P returned an average of +5.3%, well above the random three-month return of +1.4%. Out of the 65 weeks included in the sample, the market was positive after 62 of them (a 95% success rate). The average drawdown (i.e. worst loss) during the three-month trades, on a closing basis, was -1.4%, compared to an average maximum gain of +6.8%.

Saying that there were 65 weeks in the sample is accurate, but misleading. Many of those weeks were clustered together, so if we account for that, there were really about 17 truly unique occurrences. Even so, the results did not differ meaningfully in terms of either average return of percentage of time positive, except for the six-month return (+3.1% for unique occurrences in contrast to +9.1% reported in the table above).

When I see a study with 17 instances (or 65 if you prefer), with a 90%+ success rate, and a reward-to-risk that is 5-to-1, I cannot ignore the positive implications.

Granted, it has not been as successful during this latest bear market which must also be considered. There were four other weeks with a similarly low number of bulls (01/04/08, 02/29/08, 03/07/08 and 07/03/08). Three months later the S&P showed returns of -3.0%, +4.3%, +5.2% and -6.7%. That nets out to about zero, and the risk/reward was about even at -4.6% to +3.7%.

So not exactly a great buy signal lately, but during a bear market such signals can still be pretty good on a shorter time frame, and indeed since 2008 the one-month returns were positive three out of the four weeks, with the gainers averaging +3.2% and the one loser being a stiff -5.9%.

We went over several studies in December (here and here and here) indicating that what we witnessed during November marked a major bottom. But after what we went through to begin the New Year (e.g. the spike in Dumb Money Confidence and Intermediate-term Indicator Score, the failed breakout at 920 on the S&P, the subsequent losses of support at 880 and 850, and the failure to bounce off short-term oversold conditions), that probability diminished substantially.

Because of that January failure, I had been leery of buying into weakness until we either saw more of a pessimistic extreme in the Dumb Money, or an improved technical picture. The Dumb Money is currently under 40%, but that's still nowhere near the previous pessimistic extremes under 20% that we saw at prior bottoms. Even after the past week, with a couple of the senior indices threatening their lows, the Dumb Money has barely moved. That doesn't mean we can't rally, it just means that it's more difficult to define the probability of doing so.

As for the technical picture, that is undeniably dubious. The S&P 500 broke under the 800 area that had been support, and it's now hanging in a no-man's land between the November lows and that 800 area that could now act as a ceiling. Perhaps if we re-gain that area quickly, we'll again have something to work with, but so far the technical picture is not healthy.

Given the AAII data mentioned above and a few other potential positives, I can't dismiss the potential of a meaningful low forming at any point, but without an extreme in the Dumb Money and the murky technical picture, I can't find a decent risk/reward scenario for supporting a longer-term trade at this point.

On the blog yesterday we touched on the 3% down gap in the S&P from Tuesday morning:

"In the S&P 500, there have been 12 negative gaps of -3% or more (using continuous futures contracts prior to 1993, and the S&P 500 SPDR (SPY) after that date, and not including Tuesday's session).

Excluding Black Monday, the average number of days until the gap was closed was 3 days. Half of them were shut the next day, and all but 2 were closed within 6 sessions. That argues for some upside relief soon from Tuesday's opening debacle."

Several have pointed out that October 6th was also a large gap-down day and the S&P still hasn't recovered from that. It was not included in the study because according to my quote vendor the gap down that morning was -2.89%, just missing the -3% cutoff.

If we look at -2% gap opens, then we get 40 occurrences. Every single one - except that one from October 6th of last year - ended up getting filled at some point. On average, it took 5 days to fill the gap. 80% of them were closed within 5 trading sessions, though the average drawdown was -3.3% (meaning the S&P lost an additional 3% or so sometime before the gap was closed).

The market aphorism that gaps always get closed is a cliché but for the most part it holds true. That's especially true for down gaps, and especially especially true for large down gaps like we saw to begin this week.

Another potential positive is that on Tuesday the Up Issues Ratio was less than 10%, a sign of excessively skewed selling pressure. When we've seen that kind of ratio in the past, then suffered another down day the following day, the next four days were up 8 out of 8 times, averaging +6.1%. The average drawdown was steep, -4.4%, but the average maximum gain was more than twice as great, at +9.6%.

Our short-term models are oversold, and combined with the data above it seems likely that any additional weakness we would happen to see here should be made up in relatively short order. I'd rather not see a gap up opening today, but we had a wicked sell-off after the close of regular trading hours yesterday, so the gap up this morning really isn't as large as the futures would indicate. The short-term looks decent from the long side, but I'm not yet convinced a rally would be anything but short-term, and I'm not counting on potential upside much beyond 800 - 830 on the S&P.