Morning Market Comment - October 27, 2009

Good morning...We begin the day with mixed action in the pre-market futures as they swing in a tight but volatile range. We knew coming in that we should be in for a volatile week as we get hit with a deluge of economic and earnings reports, and yesterday lived up to that billing.

As a quick aside, I appreciate all the feedback from yesterday's comment regarding possible format changes. I'm wading through hundreds of responses, with some great suggestions, so I may not be able to get back to you individually right away.

One of the breath measurements that we've discussed in the past (and show for various sectors in the Sector Breadth section of the site) is the McClellan Oscillator. Recall that this indicator is essentially a look at the momentum of how many stocks rise and fall each day.

Because the indicator is based on the number of stocks traded, for an exchange-wide figure like for the NYSE the extremes can change over time. So we typically look at a ratio-adjusted Oscillator which allows us an apples-to-apples comparison to historical extremes.

Remarkably, the Oscillator hit a deeply oversold reading yesterday, nearly 2 standard deviations below its 70-year average. At a current level of -73, the Oscillator is giving off one of its most oversold readings since the March bottom...even though the S&P was within 1% of a new 52-week high at one point during the session.

Since 1940, this has never happened before. The S&P was never within 1% of a new yearly high on the same day the Oscillator dipped to -70 or below.

If we relax those parameters a bit and look for times the S&P was within 2% of a high, then a few precedents pop up. Theoretically, this development is concerning because it shows that while the broader market indices are holding up, there is deteriorating action among the underlying stocks.

S&P 500 Performance After The McClellan Oscillator Hit Oversold While The S&P Was Within 2% Of A High
Date	1 Week Later	1 Month Later	2 Months Later	3 Months Later	6 Months Later
02/09/46	1.1%	-5.0%	-0.3%	-2.5%	-17.4%
04/25/46	0.6%	0.2%	-0.9%	-3.3%	-18.1%
06/07/48	2.3%	-2.3%	-2.7%	-6.3%	-8.6%
12/18/72	-0.8%	1.3%	-2.2%	-7.2%	-12.0%
02/21/80	-2.9%	-11.6%	-10.6%	-6.9%	7.0%
06/23/03	-1.1%	0.4%	1.9%	3.9%	10.6%
06/07/07	2.5%	3.5%	-2.8%	-1.7%	1.3%

Average	0.2%	-1.9%	-2.5%	-3.4%	-5.3%

Again, this is a very rare occurrence, but the few we do have help confirm that theoretical concern.

The S&P held up OK a few times over the shorter-term of a few weeks, but by two months later it was sporting a negative return every time but once. Ditto for three months out. The best-case instance from June 2003 led to a trading range that lasted about two months, with the market really going nowhere.

When we combine this with a few other studies we've looked at recently (like the spike in buying climaxes last week, the big reversal day, and the volatile breadth readings), we're seeing some toppy kind of behavior. None of them conclusively stated that the top is in and 1100 is to October as 666 was to March, but we're seeing more and more odd readings that we haven't seen during the rally so far.

On a more micro time scale, we're also seeing an inability of the market to rally immediately from short-term oversold conditions, a rare scenario since March. All of those are warning flags and suggest an increased level of caution here, especially as the S&P wasn't able to hold 1070 yesterday.

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:	1100 has been stiff resistance, but multiple layers of support remain below
Other Tendencies:	Pullbacks after highs have been positive, but we're seeing more and more "toppy" kind of behavior

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration, or possibly even a new bull market. During April and May, we went over several studies that suggested that "this time is different" in terms of bear market rallies, as we reiterated in early May.

Since July, the market has consistently rallied smartly from the shortest-term oversold readings, as a healthy market does, and it has rolled over almost all hints of bearish conditions. That kind of momentum tends to persist for long periods of time.

We've seen some periodic bouts of excessive optimism along the way, 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.

Over the past week or so, we've gone over a few modestly convincing studies that show some cracks in the uptrend's potential. We're seeing some very volatile swings in breadth, a deterioration in the number of stocks rising along with the market, a number of big reversals after tests of recent highs, and a hesitation to rally from short-term oversold readings. All of these are warning signs, but until we actually see more of a breakdown (a loss of 1050 on the S&P would be the first step in that regard), we're giving the bull market the benefit of the doubt.

Signal Strength Breakdown	Notes
Sentiment:	Our shorter-term indicators are oversold
Trend:	Short-term moving averages are pointing higher, but there are now a series of lower highs and lower lows
Support / Resistance:	The S&P failed to hold 1070, but due to the big rally there are a series of support levels below, such as 1050
Other Tendencies:	The market has rallied well since March after multiple down days and oversold conditions

We've been looking at the 1070-1075 area on the S&P as a place that we'd probably see at least a technical bounce on the first test. We had some modestly oversold short-term conditions as well, and that combo helped propel an early rally yesterday.

That didn't last long, though, with the S&P not even able to make it back to recent resistance near 1100 before rolling over hard. That was the third reversal after early strength in the past four days, and in the process the indexes lost some interim support levels and displayed an inability to rally well from short-term oversold conditions.

That's not a great combination. The S&P is now in kind of a no-man's land as far as support and resistance goes, with 1050 the next likely support and 1088ish possible resistance. The market has rallied very well after multiple down days over the past six months, especially when breadth has been as it was the past two days (historically, the S&P was up about 73% of the time over the next couple of days when the Up Issues Ratio was less than 25% two days in a row).

So we have a few more reason to look for a relief bounce, and I'd be a lot more confident in that prospect if we can get back above 1070 and hold for a bit. If we can't, then I'll be looking for a trip towards 1050ish.