Why The Next Few Days Are Important

Posted At 9:00 AM EST

Good morning...We begin the day with flat pre-market futures after a relatively volatile early morning session.  With earnings about to pick up in earnest, a looming option expiration and questions about further financial bankruptcies, it seems likely that volatility will continue to be high for the next few days at least.

Sometimes the market makes a big move that you expect, or at least don't not expect, and sometimes it just shocks the hell out of you.  I have to say yesterday was the latter.

There was a lot lined up to suggest that yesterday morning's gap up based at least in part on Intel's earnings release would not be sustained.  Perhaps a bit more upside after the open and then a failure in the coming days, but morphing into a solid trend day was way outside the norm.

There were certainly some odd aspects about yesterday's trading.  For example, for the first time in history, both the S&P 500 and the VIX implied volatility index rose as much as they did.

In an intraday note yesterday we went over the other dates when the S&P rallied so much and the VIX also rose, and generally it had a modest bearish bias over the next couple of weeks.  The suggestion among options experts I know is that it was panic covering of short call option positions ahead of expiration, which seems as likely to me as anything.

The other standout aspect about yesterday was the breadth.  Using composite figures, yesterday was the first time since August 1982 that the both the Up Issues Ratio and Up Volume Ratio were greater than 88.5% on the same day...after the S&P 500 had already risen for two straight days.

I think that latter condition is important.  It's not necessarily rare to see such a strong breadth day when coming immediately off of a multi-month low.  But it's more unusual to see it after there was already something of a recovery out of the low.

Since 1940, this has happened 14 other times.  A week later, the S&P was positive 6 times, negative 8 times, with an overall average return of +0.2%.  There's nothing particularly notable about that.

Here's where it gets interesting.

In the afternoon note yesterday, we looked at dates when our shortest-term model, STEM.MR, went to such a notable extreme as it did yesterday.  Pretty much without exception, it marked either a peak before a dramatic fall or the initial kickoff to another multi-week thrust higher - there wasn't a lot of in-between there.

Typically when we see these kinds of setups, the next few days can be a good guide to the next few weeks.  If the market is able to follow through on the upside, then that usually means it's going to keep going, and not roll over.  But if it falters, then the short-term extreme most often marks an important peak.

The same goes for the breadth thrust we saw yesterday.  Let's look at the 14 occurrences of 88.5% Up Breadth and Up Volume days, and separate them out by the dates that showed positive one-week performance, and negative one-week performance, to see how the S&P then did over the next month.

First, the positive:

Pretty good results here.  When the S&P managed to tack on further gains after its breadth thrust, then it continued to perform well over the next month, averaging an additional gain of +4.8%.  Drawdown was minimal, averaging only -1.0%, while the maximum gain was a very healthy +5.9% on average.

Now let's look at the other side of the coin, those times when the S&P faltered after the initial breadth thrust.

Here is doesn't look nearly as good.  Over the next month, the index managed to rally twice (once just barely), but fell back six times.  Other than two occurrences, the maximum amount the S&P rallied was under +2.3%, while it lost more than -4.0% on five occasions.

Based on this data and the extreme in our shortest-term guides, I'll be basing a large chunk of my intermediate-term outlook on how the market performs through option expiration and into mid-week next week.  A continued climb higher, particularly above 950ish in the S&P, should be unequivocally bullish and project a move into 1000-1050, with less chance of a "false" breakout.  But if we roll over from here, it'll become just another bear market rally and likely lead (finally) to 800-850.

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, the market held up extremely well in spite of some 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 were - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I was looking for the S&P to run into trouble if it traded into 940-950, which happened early in June.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

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.  Now that that's happened and we're nearing the opposite end of the May - June range, we need to see how the market responds to short-term oversold conditions, especially now that we've seen a "failed" rally above the 200-day average.

So far the market continues to do that well, bouncing at least moderately off short-term oversold conditions and technical support.  The rally the past few days has put an exclamation point on that, so it continues to be too early to put a fork in the rally.  Given the extreme short-term overbought conditions after Wednesday's rally and the breadth thrust we looked at above, the next few days should tell us a whole lot about our prospects in the coming weeks.

Bottom line - Short-term Outlook:  25% Bearish (since July 15, SPX 916)

As my friend Todd Harrison likes to say, "Sometimes you're the windshield, and sometimes you're the bug".  Yesterday was definitely a "bug" kind of day, as the market crushed any seemingly ridiculous notion of being overbought or at resistance.

Yesterday my thought was that I'd be shocked if the S&P managed a sustained move above 920ish, due to the variety of factors I outlined.  Whether yesterday afternoon's move will be sustained is questionable, but there is no question at all that the index moved much farther and faster than I thought probable.

Like I wrote above, the next few days should tell us a lot about our prospects into the dog days of summer.  If we can hold these levels and perhaps even see a breakout over the June highs, it would be exceptionally difficult to argue with the positive implications of that.  On the other hand, if we just roll over as we did after several of the other extreme STEM.MR Model readings we touched on yesterday afternoon, then another break of 875 should be in store.

As of right now, we'll just have to wait and see.  We're incredibly overbought according to a variety of short-term guides, and the market has had a very consistent tendency to pull back after multiple up days and gaps like we've seen the past few days.  So most objective measure I look at is screaming for a pullback - the one (big) caveat is that if we are indeed in the midst of one of the exceptions, the move higher could be unrelenting.

All the best,