The Range Shouldn't Last Much Longer

Posted At 9:00 AM EST

Good morning...We begin the day with some buying interest in the pre-market futures, as they've ticked up steadily during the overnight hours.  There wasn't much of a reaction at all to the GDP release.

Yesterday we took a look at the percentage of Neutral responders in a sentiment survey of individual investors.  Perhaps because of unusual moves in other markets, mom and pop investors have moved to the sidelines to a degree rarely seen.

Or perhaps it's because stocks have gone absolutely nowhere for a month.  If the S&P manages to gain a bit more today, then we'll have had four straight weeks where the weekly highs were all within 0.75% of each other, and the weekly lows were all within 0.75% of each other too.

Almost a perfect square.

This kind of chop tends to raise the frustration level of most folks, but the good news is that it shouldn't last much longer.  Only 17% of the time, this kind of box stretched out for another week, and only once since 1928 it went for six weeks.  So there's that.

The last time we saw this tight of a four-week cluster of weekly price highs and lows was at the end of 2006 through the first week of 2007.  After that fourth week, the S&P poked lower early the following week then rallied strongly.

It turns out this was more common than not.  The first move out of these clusters was usually lower - the S&P was positive the following week only 32% of the time (11 out of 34 instances).  Using S&P 500 futures prices since 1982, the next week was up only 1 time out of 7 tries.

But that first move lower didn't always (or even often) continue.  The S&P cash index was positive 62% of the time over the following month; the futures were up 6 of the 7 times.

If the market was up in the three months prior to the tight four-week range, then the next week showed a positive return only 27% of the time; if the market was down prior to forming the range, then the next week was up 50% of the time.

Volatility clusters are usually a bull market phenomenon, and this one is no different.  Out of the 34 cases in the S&P, 30 of them occurred during bull market environments (a rising 52-week moving average).

The last bear market instance was way back in 1963.  Given that and such few instances, we don't really have a good template for what we're seeing now.  For what it's worth, out of the four bear market instances, the next week was lower half the time, then the S&P recovered quite well.  A month later 3 of the 4 were positive, enjoying an average gain of +4.4%), and three months later all 4 were positive by an average of +6.4%.

Many times, the first move out of these kinds of volatility clusters will be a "fakeout".  If the S&P set a new one-month high the next week, then the week following that the index was positive only 31% of the time (4 out of 13 instances).  Over the next month, it was positive 54% of the time, about in line with random, but the average return was only +0.08%.

If the S&P broke to the downside, though, then the next month showed a positive return 75% of the time (15 out of 20 instances).  14 out of the last 15 occurrences, dating back to 1961, led to positive one-month returns.

The bottom line from all this is a reinforcement of what we've often discussed here - when volatility contracts and we form ranges, traders in particular become very frustrated and eager to jump on the next trend.  But that initial knee-jerk move out of the range doesn't often, or even usually, persist.

The overall bias out of these ranges tends to be lower, but even more than that I'll be using the breakout (or breakdown) as a warning sign that we may very well be seeing a false move.  I would be particularly on the lookout for a more substantial peak in the market if we break to the upside during the first week of June and pop higher into 940-950.  Conversely, I'd probably be more interested in buying than I've been in awhile if we break down towards 830ish early next month.

Bottom line - Intermediate-term Outlook:  Neutral  (since April 9)

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.

During mid-April, 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 held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated in early May.

The S&P 500 broke out over 875 a few weeks ago, and has since re-tested that breakout level twice, holding firmly both times.  This makes it exceptionally hard to find anything "wrong" with the rally so far.  Some preliminary uptrend lines were broken earlier this month, showing a slow-down in the trend, and there is a possibility of forming a double top if we break below 875ish (which would project down to about 830).  But unless that happens, trying to bet against this rally is a tough row to hoe.

Bottom line - Short-term Outlook:   Neutral  (since April 20)

The month-long range has provided a couple opportunities to fade short-term extremes, but the moves usually occurred outside of regular trading hours, which only serves to increase the frustration levels of most traders.

With the back-and-forth (and back again) over the past three days, it's no surprise that our shortest-term guides are mostly twisted up in neutral territory with little chance of scoring another extreme anytime soon.  We need a trend that lasts for more than a few hours to move them outside of their regular trading bands.

The last day of May has had a very modest positive bias, but hasn't been consistent enough to bank on.  It was very positive prior to 1970, was mixed from there through the 1990's, then was positive 7 of the last 10 years.

Holding through the first two days of June fared quite a bit better, especially in current decades.  Since 1974, the S&P showed a positive return during these three-day stretches 74% of the time, averaging just under +1%.  16 of the last 20 years were positive during this period, though 2008 failed to follow through on it.

So we have that positive seasonality, but not much else that I can find.  Without any real extremes among our indicators, and the market still trapped within this range, I'm doing nothing trading-wise.

All the best,