Correction Should be Tamest of the Year

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Correction Should be Tamest of the Year

Thursday, September 23rd, 2004 8:00pm EST

Dramatic Reversal Doesn’t Mean Much

Bottom Line: While Wednesday’s sell-off the day after a new rally high was dramatic, history suggests that it is not necessarily an ominous sign of things to come.

In an intraday comment sent out last night, I outlined the results of similar days to yesterday. What was notable was that the S&P 500 made a new one-month (21-day) high on Tuesday, then closed below the lowest low over the prior two weeks. This is a very dramatic pattern, as can be evidenced from the tremendous amount of analysts and traders now calling for a further decline.

Out of the 42 years of history that we studied, such a pattern occurred only six other times: 9/26/63, 1/9/86, 5/8/89, 11/15/91, 7/20/99 and 1/4/00. Despite all the attention on the current situation, historically and somewhat surprisingly, past instances did not lead to anything consistently dramatic. Below, we show the five most recent occurrences with the “breakdown” bar highlighted in red. For our current situation, that would coincide with Wednesday’s decline.

While we certainly cannot discern any statistically significant nuggets from a mere six instances, there are a few points that I think are noteworthy regarding this pattern:

Out of the 6 instances, the S&P recovered enough to exceed the prior high only once within the next 10 days (in 1989), but it managed to do so 3 times within the next 21 days.
Only once, in 1999, did the dramatic reversal immediately lead to a sustained and substantial correction. While the S&P continued to decline after the 1991 occurrence, losses were light and quickly made up.
The average close after 10 days was 0.7% and the S&P was higher 2 times out of the 6. However, after 90 days the index was higher every time, with an average return of over 7.0%.
It did not make any difference if the volume was higher or not on the breakdown day. This is consistent with other volume-based studies we have done – volume simply isn’t very important, at least when it comes to the market in general. I know that is heresay to most, but it is what our research supports.

Perhaps the biggest takeaway from looking at these prior instances is that the two times that lead to a further immediate correction (1991 and 1999), price continued to drop by the 2^nd day after the breakdown day. In the other occurrences, prices began recovering by that day. Again, since there are only a handful of data points, it’s difficult to draw any meaningful conclusions, but it does suggest that how traders react over the next few days could be important to determining the bigger picture. If we continue to decline without much of a pause, this pattern’s precedent would suggest that we are in for several more weeks of weakness. On the other hand, if we can stabilize and gain some upside traction, Wednesday’s decline could be made up fairly quickly.

Rydexers Still Not Believers

Bottom Line: Traders in the Rydex series of leveraged mutual funds are acting very skittish about this rally, which suggest that this correction should be less severe than the others this year.

On September 12^th, I noted an unusual amount of hesitancy to embrace the rally as demonstrated by Rydex traders. At the time, my thought was that prices would have further to go on the upside until we saw a change in behavior in indicators such as our Beta Chase Index. Just a couple of days later, on the 14^th, the Beta Chase Index did indeed spike up close to 5, meaning that at that point Rydex traders were essentially five times more likely to invest in a “risky” mutual fund than a “safe” mutual fund. While a warning sign, it did not reach the heights that it did at previous peaks.

Now that we are undergoing the first real substantial correction since the rally began, we can see just how skittish these traders truly are regarding this rally. Below, I have updated the chart I showed on the 12^th, which highlights just how much of a lack of interest traders have in being long here.

As recently as July 30^th, there was over $900 million invested in the leveraged long index funds that Rydex offers. Remember, these funds are levered 2-to-1 to the performance of the S&P 500 and Nasdaq 100, so for each $1 the indexes gain or lose, the Rydex funds gain or lose $2 respectively. By focusing on the leveraged funds, I believe we can get a better handle on the true emotions behind the decisions without some of the hedging done with the non-leveraged funds.

The $900 million in the bull funds quickly dwindled to about $735 million at the August lows. Now, even though the S&P was 5% higher and the NDX was about 8% higher, there was only $746 million in the bull funds as of yesterday evening. There are also more assets in the leveraged bear funds now than there was at the low in March, though they are well off their highs at the lows in May and August.

Together with sustained high put/call readings, evidence from the Rydex funds suggests that traders have not embraced this rally to nearly the same degree they did the other highs this year. And looking at how they are reacting to the first substantial decline, those who were bullish seem quick to jump off that ship. These are encouraging signs and suggest that the decline may not be as deep as the others this year.

Conclusion

Those hoping for some kind of quarter-end rally from mutual funds and hedge funds trying to “goose” their performance by chasing stocks higher should probably try to find something else to hang onto. While I have no doubt some individual stocks are manipulated in this way, there is no evidence from our research that there is any effect on the broader market around quarter-end. Seasonality-wise, I think the bears have a better argument than the bulls, as the latter part of September tends to be quite weak.

Still, as is discussed above, there are certainly some solid reasons to expect this correction to be relatively mild. Wednesday’s sharp decline has engendered all kinds of doomsday scenarios from technicians, as the obvious break of support levels projects further weakness. The problem with that is the simple fact that it is so obvious and now “everyone” knows to expect more declines. Also, from the five examples shown above, such a dramatic reversal only lead to a waterfall-type decline one time.

Last Thursday, I said that I thought option expiration would be the catalyst for the deepest correction yet in the rally. Now that we’ve had another week of trading, I’m becoming more convinced that it will not be as deep as the other declines this year. We should have at least one more good buying opportunity this year, and it should come from levels above the August lows.

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

Disclosure: no positions

This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.