Morning Market Comment - November 3, 2009

Good morning...We begin the day with some mild selling pressure in the pre-market futures. They're well off the lows of the morning, due in no small part to a boost in confidence with Mr. Buffett's biggest deal ever, especially in an economically-sensitive sector.

Last Thursday, we discussed the extremely oversold breadth situation, and how it was setting us up for a likely short-term pop higher. However, based on some evidence of a continued "buy the dip" mentality among traders, confidence in any bounce being sustained was low.

That mentality was most evidence with asset flow in the Rydex series of mutual funds, as those traders held a strong preference for leveraged long index funds, as opposed to inverse (short) funds that would profit on a market decline. Since the July rally, these traders consistently tried to buy small dips after new highs, only to puke those positions right before the rally resumed.

Over the past couple of days, they have embarked on that purging process, with the ratio of long to short funds dropping from 2.5 late last week to under 1.5 as of yesterday's close.

In addition, a couple of other metrics of risk tolerance among those folks, the Beta Chase Index and the momentum in the Bull/Bear Spread, have come down to "excessive pessimism" levels for the first time in a month.

Every time since March that those indicators have reached this level, the correction was at an imminent end. We're not quite seeing them totally give up the ghost (the Leveraged Long / Short Ratio would have to drop under 1.0), but we've certainly seen them change their behavior quickly from just a few days ago.

We can also see a defensive mentality when looking at the distribution of funds among the broad sectors. The chart below highlights 8 sectors, and the percentage of total assets that each one has attracted (it doesn't quite add up to 100% due to some minor funds like Utilities, Transportation and Retailing bringing up the rear).

It's interesting to watch the changing preferences among these hot-money traders, as they tend to shift quickly and aggressively when spotting a trend they think will continue.

Precious Metals is the coolest kid among the clique, garnering 23% of the funds. They've backed off that fund over the past couple of weeks as gold has chopped around, and they've shifted some of that money into Energy and Consumer Products.

That bet on higher energy prices (and shares) is also evident in the latest Commitments of Traders report which showed huge speculative bets in Crude Oil, Unleaded Gas and Heating Oil. It's also a popular bet among the big-money managers that we looked at yesterday.

Technology has taken a surprisingly large dip in assets, mostly due to a huge decline in the Electronics and Internet funds which were so popular a few months ago.

Probably the most interesting one among them is Biotech, which went from more than $200 million in assets (and more than 20% of Rydex traders' focus) just a little over a month ago down to just over $50 million in assets (and less than 5% of total funds) currently. In the past couple of years, when these traders have abandoned this sector to this degree, Biotech did pretty well going forward. Ditto with Health Care.

Signal Strength Breakdown	Notes
Sentiment:	Smart/Dumb Confidence Spread is neutral
Trend: to	The S&P still has a rising 200-day average and a series of higher highs/higher lows, but the uptrend line from March has been broken
Support / Resistance:	With the long uptrend and recent correction, there are layers of support and resistance nearby
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 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.

Signal Strength Breakdown	Notes
Sentiment:	Our shorter-term indicators are oversold
Trend:	A clear series of lower highs and lower lows
Support / Resistance:	Most likely support from here is 1015-1020, but now resistance around 1070
Other Tendencies:	Still have positive seasonality, but the severest oversold conditions have moderated

Yesterday took us for a wild ride as early strength pushed the S&P up by more than a percent, but then the bottom fell out and we set a new low for the correction.

Given the confluence of short-term oversold readings we had heading into the session, that limp reaction is yet another ding against the uptrend's prospects. As we discuss ad nauseam, a market that does not reverse well from short-term extremes has a tendency to continue in the direction of the extreme longer-term.

We still have a smattering of extremes among some of the more sensitive indicators we follow, but they're less interesting now than they were yesterday. We have a little bit of positive seasonality left, plus the upcoming FOMC meeting which has generally had a positive bias.

I was looking for 1020ish to be a support level, and the futures got fairly close this morning with a low of 1026. I think that general area will prove to be a floor heading into the meeting, what with the (modest) oversold condition and (even more modest) positive seasonality. After the FOMC decision...well, we'll just have to see the reaction and the potential for the usual post-FOMC reversal.