Earnings, Economics and Divergences

05/01/09 9:10 AM EST

Good Friday morning...We begin the day with flat pre-market futures, as we enter the day with one of the least-volatile overnight sessions we've seen in quite a long time.

One of the drivers of pre-market volatility has been the release of corporate earnings updates, which is beginning to wind down.  There is another 100 or so firms from the S&P 500 reporting next week, then that's pretty much it, and it unofficially ends on May 14th with Wal-Mart.

The main factor behind the rally off the March low, at least if you listen to the media, is that both earnings and economic releases have not been all that great, but at least they've beaten expectations.  It's that whole going-from-bad-to-less-bad thing that often signals a turnaround.

We can very clearly see that dynamic in the following chart.  It shows the percentage of S&P 500 companies beating earnings expectations (as compiled by Bloomberg) and also the Citigroup Economic Surprise Index which is a three-month average of the number of worldwide economic reports that have come in better than estimates.

Both data sets show a major recovery from their troughs, and have actually rebounded back towards the upper ends of their ranges.  In fact, neither one tends to get much higher than the readings they recently recorded - there's a bit more room, but not much.

The red dots on the S&P price line show other times when both series were at levels equal to our current juncture.  During the bull market, the S&P dipped over the next few weeks or so each time, but obviously rebounded quickly thereafter.  The only instance during this bear market was in the summer of 2008 right before the "fit hit the shan".

With a recovery in earnings and economics (again, relative to expectations), it's no surprise that implied volatility has decreased as well.  As traders become more comfortable with the future, they see less need to protect against future uncertainty.

That, of course, moves in cycles and proves to be a reliable contrary indicator at extremes.  Yesterday was interesting not necessarily because of an extreme, but because while major indices like the S&P 500 were busy moving to new two-month highs, the VIX index of implied volatility did not move to a new two-month low.

We've touched on these kinds of divergences in the past without much of a conclusion, but it's always a popular topic for questions, so let's take another look.

There have been 20 times when the S&P was in a bear market and we saw this kind of divergence.  Three days later, the S&P was positive only 7 times, averaging a return of -0.5%.  That's worse than any-time returns during a bear market.

If we look at the two primary bear markets since the inception of the VIX, it's pretty clear that these divergences have led to sub-par performance going forward.

First, the 2000 - 2002 bear market:

I included the few months leading up to the actual peak to show that these conditions existed right at the peak as well as during the meat of the decline.

It's a similar scenario for the current bear as well:

These setups were fairly rare during the bear markets - but probably not because the divergences are so rare, mainly because it's pretty tough to reach a two-month high during a bear market.

The reason I suggest that is because when we look at non-bear market periods, the number of these divergences explodes.  If I showed the bull-market periods, then I'd be sitting and drawing those little red arrows on the charts all the way through the weekend.

Since the inception of the S&P 500 SPDR (SPY), there have been 423 trading days when the S&P hit a two-month high but the VIX did not set a two-month low.  It was almost as common to see days with this divergence as without from 1995-1999 and 2003-2006.

Am I reading much into it right now?  Not really.  I'm more concerned simply with the fact that the S&P has hit a two-month high than I am that there is any kind of divergence with the VIX.  If and when we transition to a new bull market, we of course will need to continually hit two-month highs - it's the behavior following that will be telling, and so far the market has done well by hanging in there.

Bottom line - Intermediate-term

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

After a 20%+ rally, several of our measures like the Indicator Score and Dumb Money Confidence reached levels that usually result in either a flattening out of the price rally, or an outright decline...especially during a bear market.

But the market has held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and a sustained breakout above a prior swing high (either 875 or 935 on the S&P 500 depending on how you define it) in spite of overbought conditions cannot be ignored given what we discussed in March.

For the past few weeks, I've reiterated that it's possible that we're in an "April 2003" kind of place and we'll just keep steaming higher as we emerge from the bear market, as some of those studies from last month suggested.  I hadn't been comfortable betting on that possibility, taking a "guilty until proven innocent" stance and waiting for some proof that buying interest was strong enough to change the market's character.

The 875ish area on the S&P has been my main line in the sand since March, and it's been a tough nut for the bulls to crack.  I mentioned yesterday in this Summary that if we see a sustained breakout over this area (say more than two days holding above), then I will have to start adjusting my thinking about bear-market behavior.

We got that breakout, but like the short-term stats suggesting yesterday morning, it failed.  So we still have not seen what I would consider to be a valid breakout over an important resistance level, and the market remains guilty of bear-market behavior (but not egregiously so).

Bottom line - Short-term

We looked at quite a few stats yesterday and the day before regarding FOMC days, gaps and seasonality.  All of them suggested that Thursday's gap up open likely wouldn't hold and we'd be trading lower over the coming day(s).

I also mentioned that if we were going to see that failure occur, then it would most likely happen during the first half-hour, and a new intraday high after the first hour would have me backing off the idea of selling into it.  That was off the mark, as the S&P made a new high nearly two hours into the session.

I noted on Twitter that of the six other times we've seen such a situation, the S&P managed to close above the open every time.  Well, not this time as we got a major reversal that took us to new lows right into the close.  That's very unusual given the strong behavior earlier in the day.

This leaves us with mixed short-term indicators, and a price pattern that looks like it should be bearish (but I can't find much during the history of the S&P 500 futures that provides solid evidence that that's the case.  We also have some fairly positive seasonality over the next couple of days as you can see from the charts on the Daily Overview page.  That's always a secondary consideration, but it's still a consideration.

That leaves me pretty much where I've been for the past week or so, without what I feel is a strong edge either way.  There was a decent setup on the short side yesterday but I wasn't able to take full advantage since we hit that higher high which threw me off a bit.  So still mostly sitting and watching for now.

All the best,