Stretching Above The Downtrend

Posted At 9:15 AM EST

Good morning...We begin the day with some very slight weakness in the pre-market futures, probably a shock to anyone who stuck around for the cascade of disappointing earnings releases after the close yesterday.  Even after the futures backed off in the last minutes of trading, it's surprising to many to see such a flat reaction so far this morning.

Since last week, we've taken a number of different looks at the recent momentum, which has been on a par with few other stretches in market history.  It has been, in a word, breathtaking.

Each of those other studies pretty much showed the same thing - price momentum like this has led to mixed short-term results, but has consistently led to further gains in the intermediate-term.  This is the exact opposite of what we looked at in July 2008, for example - when breadth was so bad for so long that it suggested yet more declines ahead.

While not exactly the same concept, I thought it interesting that this is the first time since 1991 that the S&P 500 has risen more than 10% above its 200-day moving average.

The typical interpretation of this is that the market is "overbought" during a bear market.  But like we touched on yesterday, that isn't necessarily the correct take.

Let's go back over the past 80 years and look for any other time the S&P managed to squirt at least 10% above its declining 200-day average, and see how the precedents fared going forward.

We can see from the table that once again, the short-term was mixed.  Sometimes we saw a pullback or chop at best, and a couple of other times it managed to add to its gains.  But the longer out we look, generally the more positive the performance became.

Let's take another look, and see how long it took before the S&P slipped back below its 200-day average for more than a day or two.

This is probably even more impressive than the first table.  It took the index an average of 191 trading days before falling back below its long-term average, and never did so within 100 days of first crossing that +10% barrier.

Again, what we see here is that when we reach this kind of momentum burst during a bear market environment, we usually don't see an outright collapse anytime soon.

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 week has put an exclamation point on that, so it continues to be too early to put a fork in the rally.  Given how well the market has responded to overbought conditions, it does bode well for the coming weeks.  That is in contrast to some of the other studies we've looked at (like the Fed study from Wednesday), so obviously that makes things tricky here - at least it suggests that being short in face of rising prices and continued momentum probably isn't a great idea, unless indexes like the S&P can't hold above recent highs (around 950ish).

Bottom line - Short-term Outlook:  Neutral (since July 23, SPX 955)

Our short-term stuff hasn't been much of a help ever since it got rolled over last week.  We had so many signs pointing lower into early this week that it would have been *extremely* unlikely to see continued strength, but that's exactly what happened.

Like other momentum studies, this suggests a strong bout of buying pressure that does not die easily.  It's kind of like that bad guy in every movie that always grabs someone's ankle or takes another shot after everyone already assumes he's dead.

So to assume that the uptrend is going to roll over any time soon is kinda like just shooting the bad guy once and turning your back.  It may be good enough, but it's almost certainly a mistake.

We're getting a few more indications of excessive optimism in the short-term again after yesterday, like another huge surge in Nasdaq vs. NYSE volume, and a 5-to-1 preference for risky funds among Rydex traders.  But after the mauling they took last week, I have much less confidence in the precise timing of anything "overbought" at the moment, so until the buyers decide that they're not going to push us higher...every...single...day, I'm not going to assume the bad guy's dead just yet.

In other words, I have little interest in continually betting on an immediate substantial correction until the market does something wrong.  Maybe the poor earnings from last night will be enough of a catalyst, but I thought I'd be seeing the futures down 1% this morning instead of flat or actually even up from yesterday's close, so there you go.

All the best,