Can't Count On Window Dressing

Posted At 9:00 AM EST

Good morning...We begin the day with flat pre-market futures.  The overnight session was uneventful with tight ranges in the indexes.

The morning economic data was mostly in line, and the biggest news is probably the big miss from FedEx, which caused an immediate 7-point drop in S&P when the news hit.  Since the Dow Transports didn't confirm the upside breakout in the Dow Industrials last week, many have been watching for signs of "why", and this kind of news from the likes of FedEx is it.

One of the common themes we heard last week as that if the S&P 500 broke out above 950, then surely we'd see a run into the end of the quarter.  Funds are having the best quarter in many years, and there's no way they'd let the last squirt higher get away without them.

The whole idea of quarter-end window dressing is highly questionable, as we've discussed many times over the years.  Obviously, any one time is different due to outstanding circumstances, but for the most part there is very little evidence of window dressing heading into the ends of quarters.  There is none of it in the major equity indexes, though some small-cap stocks do exhibit that kind of behavior.

Let's take a look at other times since 1928 that the S&P 500 rallied 14% or more heading into the last two weeks of a quarter-end.  The table below shows the return in the S&P during those last two weeks, along with its maximum loss and gain during those weeks.

We can see from the table that in contrast to trying to run the markets higher to make a good quarter even better, more often than not we saw the S&P settle back - maybe a reflection of fund managers trying to protect those precious gains.

Out of 9 quarters that showed such high returns heading into the last stretch, only three of them led to more gains in the final two weeks, and only one of those occurred since the 1960's when funds began to become more of a force in the market.  In fact, during the instance that probably is the best fit for our current situation, the 2nd quarter of 2003, the S&P topped out two weeks before the end of the quarter (and mysteriously formed a short-term low on the very last day of June).

While the market didn't often stage a rally, it didn't often fall apart either.  The average maximum loss almost exactly equaled the maximum gain since the '60's, so overall it was a tug-of-war between bulls and bears.

In an intraday update yesterday I mentioned that the Equity-only Put/Call Ratio looked poised to close at its highest level since the March low.  There was no flurry of call options into the close, so the ratio did indeed mark its most extreme reading since early March.

On June 9th we took a look at how successful these extremes have been at leading to short-term resumptions of the rally over the past few months, and actually the indicator has been almost perfect with both its buy and sell signals as it has bounced up and down within its range.

The biggest caveats with assuming we're going to bounce again are that nothing lasts forever, and expiration week is probably the best time for this indicator to break down (after all, yesterday's put/call ratio of 0.80 really isn't all that extreme historically).  Also, the last two signals led to the weakest bounces of the bunch, so there's some indication there of waning momentum.

Bottom line - Intermediate-term Outlook: Neutral (since April 9, SPX 843)

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.

While there have been - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I've been looking for the S&P to run into trouble if it traded into 940-950, which it happened last week.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

What's made this juncture so difficult is that despite so many signs of "this time is different" and the market doing nothing wrong, there are some troubling signs out there.  We touched on a couple very recently, like the surge in speculative trading and the return of bullish opinion.  Because of that, I've been leery of the S&P's chances to hold a breakout above 950.

With the most recent surge in the spread between the Dumb Money and Smart Money Confidence, and the tendency for initial breakouts from volatility coils to be "false", I was looking for the first breakout above 950 to be beaten back, which occurred last week.  From here, we'll have to see how the market responds to oversold conditions in order to get a better handle on whether we're seeing just another correction, or the possibility of a larger trend change.

Bottom line - Short-term Outlook:  Neutral (since June 3, SPX 924)

In the update yesterday afternoon, we looked at a table of short-term signposts that were likely to trigger.  With the weakness into the close, they did, and there are some decent signs there that we should see something of a rebound in the coming day(s).

Arguably that was the case yesterday, too, as the STEM.MR Model had become oversold and the S&P was holding above support at 920.  So it's troubling that buyers didn't have enough oomph to rally the market off of another "oversold on support" setup which had a spotless record since March.  That's a warning sign that momentum is waning and often precedes a larger trend change.  We saw this in January.

Given the multiple signposts pointing to a short-term rebound, I'm now using 905-908 on the S&P as likely support.  A continued deterioration below there, given the setups we have, would obviously be another negative and further confirmation that something has changed and we need to be much more careful about trying to buying into oversold conditions, with a return to 880 likely next.  So the next few days are shaping up to be another pretty big test for this uptrend.

All the best,