The Biggest Test Of The Bear Market Commences...NOW

03/13/09 8:55 AM EST

Good Friday morning...We begin the day with another round of pre-market optimism  as buyers try the near impossible by sustaining gains after a string of up days during a bear market.

For only the second time this year, the S&P 500 has managed to pull together three straight positive sessions.  There is some (possibly) good news to that, and some bad news.

Let's get the bad out of the way first.

The last time the index scored three up days in a row was February 9th.  That marked the top, and kicked off a month-long slide.  The time prior to that was January 27th, and the S&P topped the next day.

That has been the pattern since the bear market began - rally for a few days, perhaps enjoy another day of follow-through, and then fold faster than Jim Cramer under the harsh light of a comedian's scorn.

Since October 2007, there have been 27 times where we saw three straight up days (that includes overlap).  The next day was up only 8 times (a 30% win rate) with an average return of -0.8%.

The next three days were positive only 3 times (an 11% win rate) with an average of -2.1%.  The three winners were +0.3%, +0.8% and +1.7%...pretty pathetic given that the average losing trade was -2.5%.  Over the three-day trades, the average maximum gain was only +0.7%, compared to an average maximum loss of -3.2%.

Any time you see an 11% win rate with a 3-to-1 risk-to-reward, it's usually time to run screaming in the other direction.  Also not helping is that yesterday's session pushed many of our most reliable short-term indicators into "excessive optimism" territory, which combined give us an Indicator Score of only 19%.

There have been six times the Score got this extreme over the past decade, and three days later the S&P 500 was lower five of those times (they were 03/03/00, 03/21/00, 07/22/08, 11/26/08 and 01/02/09).

The one winner, from late March 2000, topped out on that third day and then headed straight down, giving back all of its gains over the next four sessions.

The three most recent occurrences all led to small closing returns the following day, either positive or very slightly negative.  The instances in July and November 2008 fell apart immediately thereafter, with returns of -2.7% and -8.9% the following day.  The instance in January of this year led to one more small gain the next day, then tumbled -3.0% the next and just kept on going.

Now for the good news.

When coming out of conditions like we saw heading into this week, a buying thrust like we've seen has often signaled a change in character.  On Wednesday morning, for example, we looked at a few reasons why Tuesday's "blast off" session was different than other short-term rallies we've seen during the bear market, and why closing above the prior five days' closes was important.

So far the market is acting in accordance with those other precedents by adding to the gains.  On the blog, we looked at what's happened when the market hit a new low, then scored three straight days with the Up Issues Ratio above 60% on the NYSE.

The striking part was that those instances that showed short-term upside follow-through were hallmarks of a very strong market that continued higher in the months ahead.  The last four occurrences all marked the end to bear markets.

Those that fell back in the short-term didn't necessarily collapse, but it was a much tougher row to hoe in the intermediate-term. 

We saw see from the table that when the market continued to push higher over the next several sessions, then over the next three months it was higher still each time, with a reward that was triple the average risk.  When it fell back short-term, though, the intermediate-term reward was significantly less than the average risk.

Bottom line - Intermediate-term

Heading into last week, we went over a number of indicators and studies that suggested we were very likely within days of an inflection point.  By Tuesday and Wednesday, we had a good-looking setup - sentiment had reached an extreme (the setup) and the price pattern coincided almost perfectly with past lows (the trigger).

The market failed to follow through immediately, instead continually flirting with that 681 area that marked last Tuesday's late afternoon low in the futures.  Despite intraday forays under that level, both Thursday and Friday closed above it.  We dropped just below it at Monday's close, popped right back above.  This was a messy pattern, but still basically within the confines of the risk parameters mentioned in the past studies.

After Tuesday's close, we needed to see some short-term follow-through, per the table from Wednesday that listed other "blast off" days.  We've seen the follow-through so far, and based on the tables above, if we can hold together for the next few days, it would lend even more credence to the idea that we have another one to three months of even higher prices in store.

But in order to get that, we're going to need to see something we haven't really witnessed since this bear market began - a market that does not implode after three straight up days (especially with a gap up open like today), and extremely stretched short-term indicators.  That's a big order, and like I said earlier this week, this is the biggest test of the entire bear market.

Based on everything we've gone over lately, I don't think we're going to be able to tack on further gains, at least not of any magnitude - it would be great if I'm wrong on that, but objectively it seems unlikely.  I also don't think we're going to collapse, and I would be looking at a move back towards 720 as a chance to add to longer-term long positions.  Ideally that would happen over a period of a few days that triggers some oversold readings among our more sensitive guides, but that's asking for a lot.

Bottom line - Short-term

This market has been stronger in the short-term than even I gave it credit for in the most optimistic scenario.  The 740 area that marked the breakdown from the February lows and the 38% retracement of the February-March decline is the kind of thing that turns back rally attempts with great consistency.  Score one for the bulls.

I keep hearing 800 as the next level of resistance, but I would be shocked if we made it past 775 - 780, especially if we approached it today or Monday.  If we do near those levels, I will be looking to take a short position against it (relatively small in size given the intermediate-term positives).

Adding to the idea that we're unlikely to sustain further gains, there have been 33 times that the S&P 500 futures rallied for three straight days, then gapped up at least +0.75% the next morning.  Buying that open and holding until the next day's close resulted in only 27% winning trades with an average of -0.6%.  The last 16 occurrences, dating back to 1998, were all negative.  The gap has shrunk a bit as I typed this, but even gaps of +0.5% led to extremely skewed downside over the coming two days.

Again, further short-term upside follow-through would be exceptionally unusual going forward, and would really only have major bear market lows as precedents.  But even if we do see a pullback in the coming days, as long as it's not too stiff, those precedents should mostly still be in effect.

All the best,