Morning Market Comment - October 5, 2009

Good morning...We begin the day with some modest buying pressure in the pre-market futures. The economic calendar is very light this week, and while we will be kicking off earnings season with a few reports, the bulk of the reports won't hit until the week after next.

Back in May, we took a look at gap openings in the S&P 500 futures. A "gap open" is simply a day that opens regular trading hours at a price different from the previous day's close.

It's rare to NOT see a gap in the futures of some amount, so we filtered the results by significant moves of +/- 1%. Only those days that opened 1% or more away from the previous day's close would be studied.

Fading, or trading against, gap openings is a tried-and-true strategy. There is a market axiom that all gaps tend to be filled, and for the most part that's the case. The difficult part is figuring out when the gap will get closed (by trading back to the previous day's close).

Let's reprint that chart from May that showed the probability of gaps of +1% or more getting filled during bull and bear markets.

It's no surprise that large gaps up tend to retreat more often during bear markets than bull markets, especially during the first week. Selling or shorting large gaps up during an unhealthy market and holding for a few days is typically a winning strategy (unless we're also grossly oversold at the time).

During bull markets, not so much, although historically the S&P has closed the gaps 80% of the time within three months.

That's what makes our current juncture so interesting. A lot of folks are wondering whether what we've seen lately is unusual, and whether the string of gap openings that haven't been filled is signaling something important.

The chart below shows the number of gaps of +1% or more that went unfilled for at least seven months since the inception of the futures in 1982.

Since the March low, the S&P has left open 7 large gaps up - a kind of cluster we've never seen before. This is obviously a hallmark of a runaway momentum market, but the curious thing is that we've seen incredible momentum in the past, but never so many unfilled gaps.

Unfortunately, we can't really go back any further in history than this. Prior to the inception of the futures market, true opening prices are hard to come by, and when they are they aren't very reliable. We can't use the cash S&P 500 index, since that index doesn't show "true" opening prices, and rarely gaps at all.

So we can't compare behavior since March to, say, the lift-off from the lows in the 1930's or 1970's to get a feel for whether these gaps are par for the course at a bear market bottom or if we're seeing a level of early-morning speculative fervor that is likely to be taken back at some point by the gaps getting filled.

In the months after the 1982 bottom, the S&P left only 1 gap unfilled for more than seven months, so there was no cluster there. About the only periods that we could reasonably suggest showed a cluster were in mid-1988 as we were recovering from the aftermath of the '87 crash and again in late 1998 after the mini-crash that fall. Both led to still-higher prices in the months ahead.

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:	Neutral short-term guides, just emerging from oversold
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:	Nothing especially notable about seasonality, etc., though recent pullback has had a bullish bias going forward

On Friday we discussed the idea that the gap down based off the Payroll Report was probably more of a positive than anything. Our short-term guides were already showing excessive pessimism, the intermediate-term trend of the market was still positive and large reactions to major economic reports tend to reverse themselves in the day(s) ahead.

The market recovered rather anemically on Friday and is up a bit more this morning. That has pushed our shortest-term guides back into neutral territory. After similar strings of consecutive lower highs, lower lows and lower closes, the S&P has had a strong tendency to see a higher close within a couple of days (about 90% of the time), though returns have been volatile. We should be able to see a recovery at least back to the recent break of support around 1035-1040, but if we can't hold Friday's reversal and break those opening prices, a move down to intermediate-term support at 995-1000 should be in order.