Breadth Sucks, But Rydex Traders Don't Care

Posted At 8:45 AM EST

Good morning...We begin the day with a gap up open on a better-than-expected GDP report.  After the past few days, and with month-end approaching, traders are jumping on whatever good news they can latch onto.

Yesterday we looked at what happens when the McClellan Oscillator becomes grossly oversold, then gets even moreso.  That's what happened this time, as it went from -84 on Tuesday to -114 on Wednesday.  As we saw from the tables yesterday, that's a less-than-encouraging sign going forward.

That reading from yesterday is a remarkable thing, especially for a market that is a mere few percentage points from a one-year high.  The -114 level has been exceeded only twice in the past decade - right after 9/11 and during the tumult in mid-October 2008 (it came very close in February of this year, but didn't quite reach this extreme).

This is only the fifth time in nearly 70 years that the Oscillator hit -110 or worse within 10 days of setting a new one-year high.  Interestingly, the others all preceded some additional short-term selling pressure, but they also bottomed about a month later and all went on to carve out new highs again.  The dates were 07/21/44, 10/22/51, 07/28/75 and 04/14/87.

The reason for such an extreme is the horrible breadth lately.  The past four days have all seen the the NYSE Up Issues Ratio close below 35%, and yesterday's was the worst of all.

Since 1940 there have been 17 times that we've seen four days with a Ratio under 35%, and the last day was less than 15%.  Over the next two days, the S&P 500 managed to rally 13 times with an average return of an impressive +2.5%.

If the market did as it should and rallied in the short-term, then that really didn't predict anything consistent about the intermediate-term.

But here's an interesting wrinkle.  Of the four times it was not able to rally, it was a very bad omen for the next two weeks.  The S&P lost an additional -5.2% on average, and it was consistent among them (-6.5%, -4.3%, -3.1%, -6.9%).

Here's another fact...that last-ditch two-week decline marked an intermediate-term low every time, or very close to it.  Over the subsequent month, the S&P sported an average return of +7.3% with all four in positive territory.  Those dates were 05/25/62, 09/12/74, 10/20/78 and 03/06/80.

The readings that are most skewing the indicators we watch are almost all related to the market's breadth.  So many stocks have gotten hit over the past week that we normally see a relief bounce.

But sentiment-wise, not a whole lot has changed.  We're seeing some increase in put option activity (from very low levels, however), but other than that there really are not many of our indicators that have moved much at all.

A great example of that comes from Rydex traders.  These guys and gals have a hair trigger, and will jump quickly when a new trend appears to emerge.  So watching this data can give good signals on both shorter-term and longer-term time frames.

Over the past few months, there has been something of a change in the behavior of these traders.  As the rally matured, their methodology changed.

Typically, these traders will buy aggressively as prices rise, and sell as prices fall.  So when the market is near a new high, almost by definition these traders are quite long and hoping for a breakout.  When the market dips, they pull in their horns and see how far the pullback goes.

But that exceptionally persistent uptrend in July seemed to smack these traders upside the head and it changed the way they trade.  Since then, they've been selling when the S&P 500 neared a new high (betting on a "false" breakout) and they've been buying after a day or two of downside.

Unfortunately, most of the time this didn't work out.  When the market pulled back and these guys bought heavily (the red dots on the chart), we had at least a bit more downside to go...just long enough for them to sell down their positions.

And when the market was testing new highs, and these traders were selling heavily (the green dots), the S&P managed to break out and hold long enough for these guys to get bullish again.  What a twisted beast.

Currently, we're seeing one of the more severe corrections of the bull market, particularly in some of the more speculative areas of the market like small caps, and the "buy on a pullback" mentality still seems alive and well.  In the leveraged index funds, there is still 2.25 more assets in the bull funds than the bear funds, and in the non-leveraged funds that ratio is even higher.

We should be near a bounce now, just based on the extreme breadth readings.  It would be very unusual to not see a little relief from the readings of the past four days.  But we would seem to have a higher probability of something more lasting if we saw sentiment shift to more of a pessimistic extreme, which we don't have much evidence of yet.

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Intermediate-term Signal Strength:    Neutral since Apr 9th (843 SPX)

(click here for archive)

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 were warning signs, and now the S&P 500 has violated its uptrend from the March low.  It is still showing a series of higher highs and higher lows, and will until it drops below 1020, but the intermediate-term trend has lost one leg of its bullish stance.

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Short-term Signal Strength:  Neutral since Oct 5th (1029 SPX)

(click here for archive)

I don't rely too heavily on seasonality, but it's hard to ignore certain parts of the calendar, including what we're now entering.

The five-day window covering the last two days of October through the first three of November has been positive 72% of the time since 1928, averaging +1.2%.  Over the past 30 years, it was 80% positive with a return that averaged +1.9%.  Notably, the average drawdown (worst loss at any point during the five days) was -0.7% while the maximum gain averaged +3.1%.

That seasonally positive window is occurring in concert with some truly extreme levels in our shorter-term indicators.  They're mostly price- and breadth-related, but we're seeing enough indicators in extreme territory to move the Short-term Indicator Score to 81%, the most-stretched level in nearly a year.

We're getting a gap up open based on the GDP numbers, so it looks like we'll be getting some relief from the past few days, at least temporarily.  The Rydex data that we looked at above is a minor negative, and it's surprising we haven't seen more of a pessimistic shift given the selling pressure.  But we've hit a true extreme in oversold breadth, and that should be good enough for a multi-day bounce...I'm just less convinced it will expand into another sustained run to new highs.

All the best,