This Time Is Different?

05/08/09 9:00 AM EST

Good Friday morning...We begin the day with some buying interest in the pre-market futures as traders react to the official stress test results from yesterday afternoon and the fairly anti-climactic jobs report.

The most common debate I've seen among traders, and something I'm struggling with myself, is whether this is just another bear market rally or something more meaningful.

Obviously there's no way to know ahead of time, but we can try to use clues to piece together the most likely scenario.  In early March, we went over a number of reasons why we should start looking for a one- to three-month rally to begin within days, and had a pretty good idea that it was imminent on March 10th when we set a higher intraday high after the first hour of trading.

Since then, we've looked at a number of different reasons why this rally was likely different than the others we'd seen so far during the bear market:

March 11th - New all-time extremes in TICK, Advance/Decline, Up/Down Volume

March 12th - 30-year high in insider buying; New low in penny stock speculation

March 18th - Decade-low allocation to stocks on Wall Street; Up Volume thrust

March 19th - Market hits new low, then up 6 out of 7 days

March 24th - A never-before-seen cluster of 90% Up Volume days

March 26th - A notable display of trend persistency

April 6th - Four straight positive weeks after a 52-week low

May 4th - More money market than equity mutual fund assets; Flip in Summation Index

May 5th - Most overbought breadth in six years

All of these have suggested that we're seeing something different this time, and so far that has played out pretty much perfectly with how it should.

Maybe the most telling of all is that in mid-April we discussed several measures that were showing excessive optimism, and it would be extremely rare to see the market continue higher if we were still in a bear market environment.

But continue higher it did, and when the market does something it shouldn't do, I stand up and pay attention.  This is why I like to watch reactions from short-term extremes so much - a failure to react off short-term extreme conditions is very often a precursor to an intermediate-term trend change.  Likewise, a failure to react off an intermediate-term extreme is usually a precursor to a long-term trend change.

Several of our indicators have started to move out of their typical bear market ranges, particularly the ones they carved out during the past 18 months.  Two good examples of that are below.  Both have reached points that are beyond what we've seen during this bear market, but well within the ranges of the prior bull market.

For the latest week, AMG Data shows that investors poured $2 billion into equity mutual funds, the 2nd-highest amount of this bear market (behind the last week in December, which was influenced greatly by seasonality).

The four-week average is now equal to where it was on 07/25/07 and 05/21/08, after which the market tumbled both times.  But prior to that, the current readings would have been considered normal and not showing any signs of excessive optimism.

We're also seeing notable readings in the InsiderScore.com Buy/Sell Ratio of corporate insiders.  We touched on this a couple of weeks ago, and again the market has continued higher and the indicator has gone on to hit a new extreme.

We're now seeing the weakest ratio of buying to selling since the middle of 2007.  Every time during the bear market it has even nearly approach the current level, stocks headed south faster than a seasonal worker who just spotted an INS inspector.

From the studies mentioned above and the apparent transitioning of many indicators into prior bull market territory, we're seeing more and more evidence that we are not getting "just another rally".  Obviously, it's possible that the market is just stringing us along, teasing us until we convert and then turning right around and knifing us in the back.

If that's the case, then based on the current extremes in the indicators above, the Smart/Dumb Confidence Indexes and the Indictors At Extremes, we should be feeling that sharp pain in the back sometime soon.  The best heads-up that we're about to get rammed would probably occur if we get some short-term oversold readings that don't result in a rally quickly thereafter, and/or a bounce from obvious support (like 875 perhaps) that then rolls back over and violates that support.  I'll be watching for both very closely.

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 during mid-April 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.  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.

The 875 area on the S&P was my main line in the sand since March, and it was a tough nut for the bulls to crack.  I mentioned last week 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 the breakout, and so far it has stuck.  There is a remarkably persistent bid underneath this market, and there are no signs yet that it is easing (see the comments from Monday, Tuesday and Wednesday for more evidence).

This has the appearance of one of those trends that creeps and creeps and creeps higher, making mincemeat out of all kinds of overbought indications, until one day we finally flush the air pocket and wipe out a month's worth of gains or more in a few days.  February and June 2007 come to mind.

But as we've discussed since March, we have more and more evidence that this is something other than a typical bear-market rally, and because of that I'm going to have to become and less and less interested in trying to game "overbought in a downtrend" until we see an overwhelming number of extremes pointing to a likely imminent reversal, or failures on a shorter-term basis like we discussed in the comment above.

Bottom line - Short-term

Yesterday morning we touched on the fact that the market has held up exceedingly well in spite of a spate of short-term negatives.  On the downside, it was gapping up to a multi-month high, which had pinpointed short-term market peaks all five times it has happened in the past decade.

The selling pressure yesterday served to move the intraday versions of our shortest-term indicators close to or into oversold territory, particularly on the Nasdaq 100.  That index is of particular interest at the moment, for three reasons:

1.  The extreme inflow into tech-related funds at Rydex that we discussed yesterday

2.  The fact that the NDX has now broken its clear uptrend from the March low

3.  The oversold STEM.MR Model (intraday) for that index

A classic trend change from up to neutral would show a bout of extreme optimism, a break of the uptrend, then a failed rally.  We have the first two conditions on the NDX, now we need to see how it reacts off these short-term oversold conditions.  A rally back towards 1410-1420 that cannot hold would suggest a much tougher ride for that index in the coming weeks.

All the best,