Stuck In A "Blah" Market

03/31/09 9:00 AM EST

Good Tuesday morning...We begin the day with a bit of pre-market optimism as markets recover from a very bad session yesterday.

We have a pretty full place of economic releases coming out this week, most notably the jobs report on Friday.  The releases have been coming in stronger than expected lately, prompting the question of whether the recent rebound in stocks has already anticipated "less bad" conditions.

The chart below shows the Citigroup Economic Surprise Index, a rolling three-month average of surprises in global economic releases.  A reading above zero means the economic releases have been better than expected, and vice-versa.

We can see that while the three-month average is still negative, it has rebounded strongly from its depths last fall (a record low, by the way).  After consolidating a bit during February, the index has moved strongly higher during March.

That should be a good sign, I suppose, but over the past six years or so the index has been a better contrary indicator than anything.  That's not terribly surprising - like almost everything else, when things look their worst and economic releases have been badly missing estimates, then often we're near the trough.

Conversely, when things are so good that the economy is seemingly hitting on all cylinders, then it's time to pull back.  Witness the spike higher in the index in August 2007 (a three-year high in economic "beats")...right as the stock market was topping out.

The index has a ways to go before I would consider it a possible contrary indicator, but it does make me wonder how much longer better-than-expected economic releases will be able to help goose the stock market higher.

Last week, we looked at the remarkable persistency of the recent uptrend, which bode well for the intermediate-term health of the market, but at the same time we had become overbought according to that same breadth measure.  Also, on Friday we looked at Rydex traders, whose enthusiasm for the rally helped push our longer-term Indicator Score into excessive optimism territory, a bad sign.

In large part because of those conflicting signals, it seemed appropriate to look for a much more choppy environment.  Based on prior studies, a wide multi-week or perhaps multi-month trading range between 730ish and 875ish on the S&P 500 looks most likely.

We couldn't quite make it up to the upper end of that range before the pullback of the past couple of days, but yesterday's performance was enough to generate an extreme in our shortest-term guides, and once again the market seems to be responding almost immediately to that.

Normally I prefer to see gap downs after big down days, just to give an extra cushion and extra sign that selling pressure has been extreme.  But during this bear market, it has actually been better if the market gaps up.

There have been 12 times the S&P futures gapped down and then lost as much as they did yesterday.  If they gapped up the next morning, then they closed that day higher than the open 9 of the 12 times, averaging +1.1% (only one occurred on the last day of the month, in September 2008, which closed +4.5%).  But if they gapped down, then they closed higher than the open only 2 out of 6 times, with an average of -1.3%.

The last day of a month has not had much of a bias during this bear, though the last day of a quarter has been positive 4 out of 5 times.  Historically, the last day of a quarter in the S&P 500 (since 1928) has been positive 57% of the time with an average of +0.1%, no real edge there.  That doesn't change much at all during bear-market periods.

April has been the third-most consistently positive month in the S&P behind November and December.  Overall, only five days during April have averaged a negative return, the lowest number out of any other month, but the returns (both upside and downside) have been more muted than just about any other month, except perhaps the dog days of summer in June and July.

During bear markets, it has been positive only 50% of the time, however the negative instances were skewed prior to the 1970's.  Since 1974, 9 out of the 10 bear-market Aprils have shown a positive return, averaging +3.3%.  Out of those 10, if March was positive then April was up 4 out of 5 times.

Bottom line - Intermediate-term

Nearing the end of the first week in March, we went over a number of indicators and studies suggesting that we were very likely within days of an inflection point.  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 on the upside, which was messy and somewhat unusual, but still basically within the confines of the risk parameters mentioned in the past studies.

After March 10th's "blast off" day, we needed to see some short-term follow-through, per the tables from Wednesday and Friday that week.  We unquestionably saw that, which basically means that it would be unprecedented to not see generally higher prices over the next one to three months.  Pretty much everything we've looked at since then helps confirm that.

Over the past couple of days, after the 20%+ rally we've seen, my outlook has been growing a little dimmer.  Instead of putting any kind of handicap on the upside, it has seemed more likely that we would be entering a multi-month trading range, with 875ish the likely upper end of that.  As we near that general area, with the readings we're seeing as noted above, it makes sense to expect the risk/reward to tilt more towards the "risk" and less towards the "reward" on long positions for now.

Bottom line - Short-term

On Friday, we looked at Thursday's exceptionally positive trading, which ironically enough has led to pretty negative returns during the bear market.  Combined with some of the other negatives, such as the 10-day Up Issues Ratio, the Equity Put/Call Ratio and Rydex traders, it seemed as though the upside should be fairly limited and further gains likely only temporary.  Even seasonality provided no objective help to the bulls.

The intraday version of our most sensitive indicators hit oversold levels late Wednesday afternoon, and the markets responded extremely well, something we haven't seen for awhile.  The STEM.MR Model for both the S&P 500 and Nasdaq 100 reached extreme oversold levels again yesterday afternoon, and again we're seeing a positive reaction soon thereafter.

Yesterday's trading unfolded pretty well in line with the precedents we went over in the morning comment.  Based on today's (so far) gap up following such a negative day, we should see higher prices yet today, especially given the oversold nature of the STEM.MR Models.  While the stats above suggest that today's gap up should be a positive sign, I'm never too enthused about chasing gaps up during bear markets.  I would have been much more interested if we'd seen a drop towards 740-760.

All the best,