Morning Market Comment - October 12, 2009

Good morning...We begin the day with a surge in the pre-market futures to a new recovery high for the S&P 500. This might trigger some increased volume, though with the Columbus Day holiday that's a toss-up.

This is the one-month anniversary of our daughter being mainstreamed into Kindergarten, and so far it's been better than I feared. It started out rocky - too many new things all happening at once - but after that she's been making progress seemingly every week. That's the kind of reversal we were hoping for, and obviously hope it continues.

Speaking of reversals (ugh, sorry about the segue), a couple of weeks ago we looked at pullbacks from a high from a couple of different angles, such as the supposedly bearish Key Reversal Day from September 23rd, the downside follow-through the next day, and then multiple down days after becoming more than 20% stretched above the 200-day moving average.

Those studies suggested strongly that while the recent correction was disconcerting (they always are...), the historical probability was high that the S&P 500 would reach a new six-month high within a few weeks.

Various price vendors have slight discrepancies with data, but according to mine the S&P just barely missed closing at a new high by 0.17 points. Given the move in the futures this morning, I think it's safe to fudge a bit, so let's say for now that this time it took 10 trading days to reach a new closing high with a maximum drawdown of -1.8%. That's not too far off the averages from the precedents we studied.

So now let's look at those other instances when the S&P suffered a Key Reversal Day, showed some downside follow-through, and then recovered to close at a new six-month high again.

What we're looking at in the table below is the S&P's performance going forward after it recovered enough to close at a new high.

Well, not too much to go on here - the returns are pretty ho-hom. There weren't any major declines over the next few months, just a couple of drops of 3%-5%, all of which recovered. There was that one instance in August 1989 that just kind of hung in negative territory before a larger drop looking out six months, but other than that no big declines.

On the upside, it was a little more interesting. Seven of the ten showed at least a +4% return at some point during the next three months, and longer-term the average did beat a random return. But there isn't anything here that's jumping up and down saying what a wonderful (or terrible) development it is that the S&P has recovered from the supposed-to-be-so-negative Key Reversal Day. I think the usefulness of that study has already served its purpose.

There was an article on Bloomberg on Friday that suggested the recent surge in stocks hitting new 52-week highs was a sign of a sustainable rally, and was nothing but good news looking ahead.

A surge in 52-week highs is not a surprise, of course, given that 52 weeks ago was October 17, 2008 (depending on how your source computes new 52-week highs). That was during the very worst of the selling pressure, and near a temporary, convulsive bottom when the S&P was trading at 940. Even if the S&P just stands still from here, we'll probably see another big thrust of 52-week highs as the prices from last November's dive drop off.

Late last week, my data also shows a surge in NYSE new highs, with more than 400 securities hitting that threshold.

If we go back to 1995 and look for all times the NYSE did not have more than 400 stocks hitting a new high, then the average maximum gain over the next month was +3.8%, while the average maximum decline was -4.1%.

But If the NYSE did have more than 400 new highs, then the max gain averaged +2.4% while the max loss averaged -2.7%. In other words, the market tended to gain (and lose) less over the next month when there was a surge in new highs, but its average decline was more than its average advance.

If we had the best of all worlds, and not only did the NYSE show more than 400 new highs, but the S&P also closed at a six-month high at the time, then the max gain averaged +2.2% while the max loss averaged -3.2%. Meaning that the more supposedly positive the conditions, the worse the S&P's risk/reward was going forward.

The last time we saw that combination was on June 1, 2007...and the S&P went into an immediate four-day, 3.2% slide before recovering ever-so-slightly in July and then suffering an even worse setback in August. This surge in new 52-week highs is both a factor of mere timing (because of last October's bloodbath) and a shaky crutch upon which to lean on a bullish outlook.

Signal Strength Breakdown	Notes
Sentiment:	Smart/Dumb Confidence Spread is neutral
Trend:	Positive given a rising 200-day average, uptrend from March is still intact
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've been watching how the markets recover from the Key Reversal Day from a couple of weeks ago. Right in line with its precedents, it has recovered well, and so we continue to see very little evidence of major topping action. We don't have too many sentiment measures arguing that we're seeing long-term signs of excessive optimism, and the technical action of the market has been superb. Until either one of those changes, there isn't much reason to expect a major change from what we've seen over the past six months.

Signal Strength Breakdown	Notes
Sentiment: to	The STEM.MR Model is slightly overbought, as are several of our other shorter-term guides
Trend:	Short-term moving averages are pointing higher, the S&P futures have hit a new high
Support / Resistance:	The futures have hit a new high, leaving various levels of probable support below current prices
Other Tendencies:	The market tends to pull back after consecutively strong sessions and big gaps up

Last Friday we noted 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 once again exploded higher from short-term oversold conditions, which mitigates somewhat the negative pattern of lower highs and lower lows that we had seen, and even that negative pattern is on the eve of being busted.

As of Friday's close, our Short-term Indicator Score moved to an "excessive optimism" reading, which we've seen several times since the March low. The market has typically faced a multi-day rest period after other such extremes, though it did not when we saw similar readings in July and September.

Those two periods saw the S&P continue to climb without really trading below a prior day's low for a few minutes as the string of up days continued. That's the biggest change I'll be looking for here - I'm just going to assume this is another "stand aside and watch it rise" period like those two, unless we see more typical behavior and the S&P trades (and holds) below a previous day's low. That would be around 1063.

There is a chance for that kind of reversal here. I need to get this out early today, so the futures could change before the open, but there have been four other times that the S&P 500 futures rose for five straight days, then gapped up at least +0.5% to a new six-month high (09/15/95, 06/06/03, 03/17/06 and 09/15/06).

The index was trading lower a week later all four times, with an average maximum gain during the week of only +0.5% compared to an average maximum loss of -1.5%. None of them gained more than +1% from the gap up open when looking out over the next week, suggesting the S&P shouldn't make it above 1085 if this is to hold up (assuming we open around 1075).