Morning Market Comment - October 2, 2009

Good morning...We begin the day with heavy selling pressure in the pre-market futures as the Payroll Report was weak across the board. Once again, paying attention to Goldman Sach's late revision was worth it.

First I want to mention that I'll be doing a live chat with Charles Kirk from The Kirk Report fame today at 11am CST. If you get a chance, please stop by at this link.

Yesterday, columnist Mark Hulbert penned a piece highlighting October's penchant for high volatility. That looked prescient given the big decline to start the month...even though the last three times the S&P lost 2% on the first day of a month, the rest of the month gave returns of +14.2%, +15.7% and +3.2%.

There have only been two other times the S&P lost 2% to begin a month when it had just set a six-month high within the past two weeks (October 1955 and December 1980). Both times, the S&P continued to sell off for about 7 days, then rallied strongly into the end of the month.

Regarding October's volatility, I want to touch on it again in response to something we looked at on Tuesday that showed how past Octobers have fared after "good" and "bad" Septembers.

Let's go with Mark's methodology of looking at October's average daily change. Here we're using the S&P 500 since 1928, and the average for all months (excluding October) is 0.73%. For October, it is 0.90%, meaning that the average day in October is nearly 25% more volatile than the average day during other months.

But here's the thing...when the S&P showed a positive return over the prior month, then the average daily change in October was only +0.60%. When the prior month was negative, then the average daily change in October was +1.24%. This is an enormous difference - the average October day after a bad September was more than twice as volatile as when it followed a positive September.

That, at least, would argue for a tamer October this year due to the S&P's decent performance last month.

The sell-off over the past few days has led to another round of oversold readings and concern about the potential of the uptrend having ended. Let's go over a price pattern process similar to what we did last week with the Key Reversal Day.

What we learned from that was that the Reversal Day itself wasn't an especially good predictor of a major intermediate-term top, and how the S&P reacted in the short-term could go a long ways to determining just low long it might take to scramble back to a new high.

The S&P did actually show a positive 3-day return after that Reversal Day, but just by the skin of its teeth.

3. The S&P dropped 3 straight days, each day with a larger loss than the day before

Since 1928, this has happened 59 times. After that third down day, we almost always saw a rebound at some point within the next couple of weeks - the S&P saw a higher close within two weeks 56 times, a 95% win rate.

On average it took the S&P just two days to notch that higher close, suffering an average drawdown (maximum loss) of -0.8%. This means that we should see a close above 1029.85 within the next couple of weeks, and probably sooner rather than later.

The three dates that didn't see a positive close were 07/22/68, 07/22/75 and 07/23/75. The former formed a bottom right at that ten-day mark and was soon hitting new highs again. The latter cluster led to another couple weeks of selling pressure, but once again the S&P was hitting new highs within a few months.

Out of these 59 instances, 73% of them were trading at new six-month highs within a month, and 85% within three months. 86% of them were at a new high within six months, which isn't much different than the percentage hitting a new high within three months...which means that if the S&P didn't make it back to a new high within a few months, then it probably wasn't going to anytime soon.

Here's an interesting twist - if the S&P was higher a week after these setups, then in 95% of the cases (36 out of 38) it managed to claw to a new high within three months (it took an average of 14 days to get there), and its worst drawdown (i.e. maximum loss) during the next few months averaged -1.4%.

But if it was trading lower a week later (by any amount) then its chances of hitting a new high within a few months dropped all the way down to 67% (14 out of 21), and the average drawdown during the next three months was a woeful -6.8%, with it taking 30 days on average for the ones that did hit a new high to do so.

Once again, it seems as though looking at how the market reacts short-term should give us a very good clue about the intermediate-term health of this trend.

Signal Strength Breakdown	Notes
Sentiment:	Smart/Dumb Confidence Spread is neutral
Trend:	Positive given a rising 200-day average, but uptrend line from March low is being threatened
Support / Resistance:	Resistance at recent highs at 1075 and then 1120; support at 995 and 950
Other Tendencies:	Pullbacks after highs have been positive

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.

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.

We'll be watching closely at how the markets recover from the Key Reversal Day last Wednesday. As noted in the comment on Thursday, short-term follow-through is key, and technically the S&P showed a (barely) positive 3-day return this time. So we continue to see little evidence yet of unbounded speculation or a change in the market's character, either of which would cause us to become more suspicious of the S&P's one- to three-month upside potential.

Signal Strength Breakdown	Notes
Sentiment:	Extremely oversold short-term guides
Trend:	Lower highs and lower lows; uptrend line from July low has been broken; uptrend from March still intact
Support / Resistance:	Broken support at 1035, next is near 995-1000
Other Tendencies:	Positive seasonality, tendency to reverse from gaps down on major economic reports

In July, the S&P futures opened down more than -1% after the release of the Payroll Report, and proceeded to lose an additional -1.5% during regular trading hours.

Historically, the futures have gapped down -1% or more on Payroll Report days 12 times, and they closed higher than the open 8 times, with an overall average return of +1.2%.

It has only happened three other times when the S&P lost at least -2% the day before (06/07/02, 03/07/08 and 12/05/08). By Tuesday, the S&P was higher each time, gaining at least +2.3% at the best point each time, and losing no more than -1.7% at the worst.

A large confluence of our shortest-term guides are grossly oversold, so when we combine that fact with the tendency for the market to reverse from large reactions to major economic reports and (modest) positive seasonality, it looks like we should see a recovery over the coming days from the recent carnage. I'd be especially interested in pursuing that if we dipped down closer to 1000 in the futures early this morning, but that's a lot to ask for.

The largest short-term negative here is the new pattern of lower highs and lower lows. This happened in early July as well, with no ill effects, but technically it defines a short-term downtrend and combined with the violation of the steep uptrend line from the July low, it's a cause for concern.

As long as the S&P can hold above 995-1000, however, I'm inclined to give deep oversold readings their due, and overall the short-term outlook from here is modestly positive.