Should Be On The Verge Of Another Breather

Posted At 8:45 AM EST

Good morning...We begin the day with some modest buying pressure in the pre-market futures after early-morning weakness was once again just another good opportunity for those looking to buy.

As we headed into the Labor Day break, there were a number of various factors coming together that argued very convincingly for a short-term pullback once traders came back from the summer break.

Based on some of the volume numbers since then it seems as though many left permanently, but whatever the reason the market rolled right over those negatives and has set higher highs every day since.

Because of that inglorious failure, it seemed best to resist trying to continually anticipate an end to the momentum until we either saw a change in character in the price action and/or another true extreme in sentiment.

Yesterday was a modest change in the price activity as the major indexes had some trouble intraday and didn't close at the very tip of the day's high.  It's not much, but the bears will grasp any bit of possible hope from that.  More notably is that we're getting another round of extremes in sentiment.

In the morning comment yesterday we took a peek at the Indicators At Extremes, which showed more than 30% of our guides at a bearish (for the market) extreme and 0% past their bullish thresholds.  Previously when we've seen that the S&P was within a day or so of at least a short-term peak.

As the final numbers came out yesterday, we got another extreme, this time in the spread between the Smart Money and Dumb Money Confidence.

Historically, this spread has stretched much further than it is now, but I'm most concerned with recent history and how the market has performed under similar conditions.

Since the March low, the spread has reached -33% four times other than yesterday (May 8th, June 11th, August 4th and August 12th).  During the following week, the most the S&P was able to gain at its best point averaged +0.6% while the most it lost over the next week averaged -3.3%.  All four lost at least -1% during the next week and only one (barely) gained more than +1% at any point.

This is obviously pretty short-term stuff, and doesn't say much of anything about the intermediate-term that's any different from what we've seen since May.  It's just another indication that the current push to the upper end of the trend channel formed over the past few months is more likely to fail in the coming days than not.  If it doesn't fail, then about the only conclusion I could draw is a parabolic upside move similar to what we witnessed in December 2003-January 2004.

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 a new bull market.

During mid-April, the market held up extremely well in spite of being overbought.  This is very rare during an ongoing bear market, and added to the idea that "this time is different" in terms of bear market rallies, as we reiterated in early May.

On July 10th, we looked at a number of short-term oversold readings, and like a good market does, it responded by rallying strongly.  The rally since then has been remarkably persistent, rolling over a multitude of indicators and studies that argued for a pullback.

As we discuss ad nauseam, a market that does not respond to short-term extremes usually has more work to do in the direction of the extreme, and that held true this time as well.  Given how well the market has responded to overbought conditions, it does bode well for the coming weeks (see here and here as well).

We've seen some periodic bouts of excessive optimism during that time, and the market has pulled back in the very short-term after them.  But each time, the major indexes have held technical support, and rallied from even intraday oversold readings, so we've seen little change in the uptrend's character just yet.

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

I've been very hesitant to anticipate an end to this latest July-wannabe push higher after the resounding failure to see any weakness following Labor Day.

After considering what we discussed yesterday and this morning, however, I once again think we're very close to another multi-day correction.  Option expiration is a convenient scapegoat for the recent push, and if it had anything to do with the scramble higher then that catalyst will be removed today and we can resume more "normal" trading. 

Out of 25 instances since 1982 that the S&P futures closed at a six-month high the day before expiration then gapped up expiration morning, 15 of them coincided with a short-term peak with more weakness than strength the following week, 7 of them rose a bit over the next week, but then gave back the gains within another couple of days, and only 3 of them just kept rising.  Given the status of our indicators, that latter case again seems the most unlikely.

All the best,