Morning Market Comment - October 13, 2009

Good morning...We begin the day with flat pre-market futures. There isn't much on the economic calendar again this week, which is just fine since we will be barraged with some important earnings releases, most notably Intel after the close today and the financials beginning tomorrow.

While most banks were closed in observance of Columbus Day yesterday, title companies weren't, and I was in Wisconsin closing on a piece of real estate. I've been watching and waiting for years for the opportunity to grab some land there, and just couldn't justify it when prices were $3500/acre and up just a year ago.

Landowners looking to get out have started to panic over the past few months, with prices falling 10% a month (!) in several cases, and now land is being offered at nearly half the per-acre cost from a year ago.

Part of the tract I closed on is an 80-acre parcel of Northern Wisconsin hardwoods with the usual critters in abundance (deer, bear, turkeys, grouse), and the seller was kind enough to bring the original abstract for the property. Its history is fascinating; a microcosm of our country's fortunes.

The land was given (for free!) in February 1860 by the United States government to an officer of the Army "for time served in honor of his country". The veteran gave the land to a buddy, who promptly sold it the following year for $12.98, the equivalent of about $41,000 today (using a relative share of GDP). It changed hands a couple of times after that, before being sold for $2000 in 1901. That was after the DJIA had doubled over the prior few years, and folks were apparently feeling flush - it was the equivalent of $1.3 million today.

It changed hands a few more times, before being bought (and mortgaged) for $600 in 1922 (the equivalent of $118,000 - talk about a loss from the 1901 sale). Those folks ran into hard times, and the bank foreclosed on the property in 1938. They turned around and sold it at a loss for $350 the following year (the equivalent of $55,000). Since then, it has again been bought and sold a few times, with nothing particularly outstanding.

History can always teach us a lesson in one way or another - how good our country used to treat our veterans, how people over-reached when times were good, how terribly bad things had gotten even years after the great crash of '29. If only more people would listen.

Back in August, we took a look at using the S&P 500's performance during earnings season as a predictor for how it may fare during the off-season.

Historically, there wasn't much of a correlation between the two, but more recently very strong earnings seasons tended to lead to strong performance during the off-season as well. That occurred yet again this time, as a +14% gain during Q2 earnings season led to a +4% gain during the off-season.

Let's flip that around now and see if the off-season has any predictive use for earnings season.

The chart below is a scatter diagram that shows the S&P's return during the off-season (horizontal scale) and the index's return during the subsequent earnings season (vertical scale).

The black line on the chart is the regression line that shows the relationship between the two - the fact that it is sloping from the upper left quadrant to the lower right quadrant means that there is a negative correlation. The steeper the slope, the larger the correlation and in this case the slope is relatively weak, meaning there isn't a lot of possible predictive power.

Still, let's take this to the next step and use the regression formula to see what it says about our potential during the next few weeks of earnings season. According to the formula, based on the S&P's return during the off-season, we should expect a return in the S&P over the next few weeks of -0.3%.

Interestingly, there was a higher correlation between the maximum loss and maximum gain during the off-season and the subsequent max loss and max gain during earnings season. Using the same methodology, the formulas suggest that we should see a maximum gain over the next few weeks of +3.8% and a maximum loss of -4.8%.

Because the correlation is weak, it would be ridiculous to take these forecasts too far. But it's useful to think in terms of potentials, and it's notable that the potential drawdown is quite a bit larger than the potential maximum upside.

Looking at the S&P's 10-best off-season performances (of which the one most recently ended just barely missed), the following earrings season showed an average return of -0.7%, with an average maximum gain of +2.3% and an average maximum loss of -4.8%, more than twice as great.

Using this regression as a (very) general guide, it would suggest that the market may have already exhausted a bit of its potential with the strong push during the off-season.

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 near overbought, and the Short-term Indicator Score is already there
Trend:	Short-term moving averages are pointing higher, the S&P futures have hit a new high
Support / Resistance:	The futures hit a new high yesterday (good) but couldn't hold it (bad)
Other Tendencies:	The market tends to pull back after consecutively strong sessions and big gaps up

There is no question that the market continues to do what it should in order to maintain the appearance of health. It rallies off the slightest hints of oversold conditions, and laughs in the face of potential technical resistance.

It didn't quite laugh yesterday, though, as the S&P tried to push to a new recovery (intraday) high and wasn't able to maintain it. There wasn't anything evident in the price pattern that I could find that was especially bullish or bearish - the textbooks would suggest that the failure to hold a new high is bearish, but historically that's tough to prove with any consistency.

Yesterday we touched on the rare feat of the futures gapping up to a new multi-month high on the heels of several consecutive up days, and each time it marked at least a short-term peak in the market. Yesterday's performance was a little bit of confirmation that we could be seeing the same here, but we still haven't traded below a prior day's low, and until that happens what we've seen so far is eerily reminiscent of the remarkable marches higher in July and September.

For now, it does look like the (modest) short-term overbought conditions and yesterday's failure to hold a new high will provide some short-term resistance, but I don't see a big reason to try to press short sales as long as we keep with this pattern of continual higher lows in the S&P. Tonight's Intel report should shake the tree one way or the other...but as we've discussed before, Intel's status as a bellwether is usually best used as a contrary indicator (i.e. surges higher typically lead to weakness and vice-versa).