Morning Market Comment - October 16, 2009

Good morning...We begin the day with the heaviest pre-market selling pressure we've seen since the 2nd trading day of the month. Since the July low, the S&P 500 ETF (SPY) has opened lower by this amount or larger 10 times, and managed to close the day higher than the open on 9 of those days, so an inability to do so today will be one (small) sign of a change in character.

As we were entering October, we saw headline after headline about October's "scary" history, letting us know that while the month tended to close in positive territory a majority of the time, its volatility was the highest of any other month.

Near the end of September, we went over a wrinkle in the data that showed that October's tendency for volatility was often confined to years when September was nasty; when September had been well-behaved, then October had a consistent tendency to follow suit.

It's safe to say that's been the case this year as well, though obviously we're only half-way through and we could get a wicked spill before month-end. But now that the first couple of weeks have passed with almost nothing but higher closes each day, we're starting to see more headlines about this time of year (and the next couple of months) being the best time to invest.

Historically that's been true. Since 1928, the S&P's average return from the end of September through the end of December has been +3.3% with 75% of all years sporting a positive return.

But what about those year when the market has already rallied heading into the fourth quarter...has that sucked some of the wind out of the last quarter?

There have only been four other years when the S&P was up 15% or more heading into October. The last quarter of those years finished higher all four times, averaging +8.1%, though it wasn't without some volatility (the average drawdown was -7.2% compared to an average maximum gain of +9.1%).

A 15% year-to-date gain is pretty hefty, so let's relax that and look at 10% gains. In those cases, the S&P was higher into the end of the year 23 out of 28 times (an 82% win rate), with an average gain of +4.1%, average max loss of -4.7% and average max gain of +6.8%.

On a relative basis, there have been 14 years when the S&P was more than 10% above its 12-month average heading into October. The table below shows the returns going into the end of the year.

S&P 500 Return From Oct-Dec When Already > 10% Above Its 12-Month Average
Date	Oct-Dec Return	Max Loss	Max Gain
1933	2.8%	-12.8%	5.0%
1935	15.9%	-4.2%	16.1%
1936	7.3%	0.0%	10.5%
1938	7.9%	0.0%	12.7%
1945	7.4%	0.0%	9.4%
1950	5.0%	-2.3%	5.0%
1954	11.4%	-2.0%	11.4%
1955	4.1%	-6.6%	6.3%
1958	10.3%	-0.2%	10.3%
1980	8.2%	-0.6%	13.2%
1987	-23.2%	-32.7%	2.2%
1989	1.2%	-6.3%	3.2%
1995	5.4%	-2.2%	6.6%
1997	2.4%	-9.7%	4.1%

Average	4.7%	-5.7%	8.3%

We can see that the there was only 1 loser out of the 14 occurrences, though that loser was a doozy due to the crash in '87. Without that outlier, the average return would have been +6.9%, with an maximum drawdown that averaged -3.6% compared to a maximum gain of +8.7%, more than twice as great.

How about those times when the 12-month average was still declining, like it was heading into this month? Well, in those cases it wasn't as positive. Then the fourth quarter averaged a return of only +1.2%, a win rate of 65% (15 winners out of 23 occurrences) and an average drawdown (-7.2%) that was nearly as large as the average maximum gain (+7.6%) heading into the end of the year.

How about if we combine those two, and look for times when the S&P was more than 10% above its 12-month average, but that average was declining? Then we only get one occurrence, which was 1938. That year, the S&P rose +7.9% into the end of the year.

Overall, there once again isn't much in these stats that suggest that we should be any more worried about the intermediate-term prospects of the market just because we've already rallied so much. If anything, quite the opposite has held true over time.

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:	The market is trading at a new high, little resistance until 1100 - 1120
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:	While the STEM.MR models are neutral, several of our other short-term indicators are at bearish (for the market) extremes
Trend:	Short-term moving averages are pointing higher, the S&P futures have hit a new high
Support / Resistance:	Yet more new highs for the futures
Other Tendencies:	The market tends to pull back after consecutively strong sessions and big gaps up

Yesterday the market once again confounded bearish tendencies. For one of the few times in the past 15 years, it managed to close in positive territory after suffering a largish gap down and not closing that gap within the first hour.

But it also triggered new tendencies that have usually led to short-term downside, such as sporting a relatively narrow intraday range, at a new high, and with negative breadth. We also saw big under-performance by the Banks and Semis, which again usually lead to a pause.

These types of tendencies would normally have me looking to sell short (in the short-term only), but they have simply not worked well lately. The tend has been very strong, we continue to hit new highs almost daily despite whatever the probabilities might say, and objectively we're not at a real compelling sentiment extreme.

So I'm continuing with my theme of the past few days - we should pull back based on the market's historical reactions to similar conditions, but there's no way I'm willing to short it yet based on the market's recent habit of thumbing its nose as these kinds of behaviors.