Snapshot Notes - September 19, 2007

My kids like to swim at the local pool, even though truth be told they're not very good. So when something comes along that disturbs the water, they tend to panic a bit.

It struck me that the Federal Reserved is kind of like the "not exactly thin" kid that just did a beautiful belly-flop off the high diving board, and the rest of us are the poor saps in the pool trying to tread water as the initial surge washes over.

When we get these types of one-off events, the typical reaction in the major indices over the next few days looks like flailing swimmers - lots of expletives, lots of splashing to and fro, but in the end not much forward progress.

That makes it tough for shorter-term traders to be aggressive. It's usually a mistake to try to chase a move like yesterday, as historically we see very mixed results in the near-term. Whether we look at performance following large up days, or extreme skews in NYSE breadth and volume, or after cuts in the Fed's target rate, short-term equity returns going forward were mixed at best.

After a period of re-adjustment, though, those mixed results turned markedly positive. We can look at it any number of ways, and we've already looked at a couple - returns following huge surges in "up" volume on the NYSE, and returns following big jumps in reaction to a Fed action. Both led to questionable near-term performance, then notably positive vibes when looking out a month or more.

That's the game plan I'm going with here, too. Our short-term guides hit an extreme overbought condition this morning, and have since rolled over, which most often equates with a market that is about to not go much of anywhere to the upside for a little while. That makes sense in combination with the studies we've looked at today and yesterday, so I'm not looking at pressing anything just now. If we do happen to get a couple of days of prices relaxing a bit, then it's hard to ignore the bullish precedents that have triggered again, and I'll be looking for a good opportunity to participate in what should be another jolt higher.

The major indices have been in a slow fade from the opening pop, but the movements haven't been all that extreme, with the S&P 500 now about equal to its opening print.

I've been doing a lot with some of the different readings that triggered after yesterday's jump, and for the most part they just confirm what we already know.

For example, there have been six instances in the past 40 years where breadth on the NYSE was skewed at least 10-to-1 to the upside yesterday, then today stocks didn't rally big (less than .75%), coming after a period where the index had already rallied at least 5% over the past month.

Looking out five days, the S&P showed a negative return every time, averaging -1.6%. But buying five days later and selling after a month resulted in five winning trades out of the six.

The same goes for returns after an initial rate cut by the Fed - very mixed short-term results, then consistently positive ones looking out a month or more.

That highlights the type of situation we're in now - short-term performance after a day like yesterday has been mixed, and it usually doesn't pay to try to chase the strength. Most often the best course of action is to let things settle for a few days, then look for an opportunity to join the long side in anticipation of more follow-through in the days and weeks following that.

I mentioned earlier that several of our more intermediate-term guides had started to move back to neutral from excessive pessimism extremes, and that's actually a good thing. That's what we need to see in order to have more confidence in a recovery from August's troubles.

For the near-term, however, that quick switch moved a lot of our more sensitive indicators, such as the ones we update intraday, into extreme territory and it's just not common to see stocks sustain additional gains in the face of that. I'm still quite positive on our intermediate-term prospects, and I anticipate the next setup I want to take will be on the long side, but for now the risk/reward doesn't seem all that appetizing.

Good Wednesday morning...we begin the day with another largish gap up open as traders continue to scramble into equities after yesterday's jump. The last time the S&P gapped up more than 0.5% two days in a row was July 31st, and historically it hasn't been all that positive an indication going forward.

Back in mid-August, we went over an exhaustive number of studies in the Daily Snapshots and Long-term Comments that suggested a healthy rally in the intermediate-term time frame of one to three months. That outlook was based on the embarrassingly large number of extremes in all manner of indicators.

It should be no surprise, then, than after a 10%+ rally in the S&P 500 in just over a month's time, many of those indications would revert back to normal. Until yesterday, we hadn't seen that too much - the Smart Money Confidence was still at 67% and the Dumb Money was just emerging from under 40%. There was a fairly big change yesterday, and based on some preliminary readings it will change again today, coming closer to the 50% neutral mark, at least for the Dumb Money.

One reason for that is the change is the Investor's Intelligence survey. We went over this one in August, as it was showing an extreme in bearishness, an unusual development for newsletter writers during a bull market. They've seen the light now, though, and there was another big change from bears to bulls, with the Bull Ratio for that survey now kissing "excessive optimism" levels, albeit just modestly.

This is not a reason to worry, at least not yet. As prices rise, we *want* to see people become more bullish - that's the only way they're going to be willing to put more money to work. It's when that optimism reaches a pinnacle that we should really worry during an uptrending market, and we're a ways from reaching that point.

Switching gears, the Fed has cut the discount rate 53 times since 1971. Out of that population, there have been only 5 times that the S&P 500 rose more than 2% the day of the cut. The following table shows the short-term returns following each of those instances.

S&P 500 Performance Following 2% Jumps on a Day the Fed Lowers the Discount Rate
DATE	1 DAY	3 DAYS	5 DAYS	10 DAYS	1 MONTH
10/30/81	+1.9%	+2.3%	+0.6%	-0.2%	+3.5%
10/15/98	+0.9%	+1.6%	+2.9%	+3.7%	+7.5%
01/03/01	-1.1%	-3.8%	-2.5%	+0.0%	+0.1%
04/18/01	+1.3%	-1.1%	-0.8%	+2.4%	+4.1%
08/17/07	-0.0%	+1.3%	+2.3%	+1.9%	+5.1%
Average	+0.6%	+0.0%	+0.5%	+1.6%	+4.1%

We can see that the immediate future was mixed. The return in the S&P three days later was greater than +1% three times and less than -1% twice. But after 10 days, all but one were positive (lone loser was very mild), and after one month all five were positive, four by +3% or more.

That fits with something we went over yesterday afternoon as well. The volume skew yesterday was so tilted to the positive side that it registered a true historic extreme, with very bullish connotations in the intermediate-term. The short-term, however, was much more mixed.

As of now, the futures indicate another gap up open. The last time the S&P gapped up more than 0.5% after it rallied more than 2% the day before was April 3, 2003. Over the past decade, the S&P has done this 23 times, and it closed higher than the opening print 14 of those times for an additional +0.3% on average. Returns in the days following reverted back closer to random.

I haven't seen anything in the studies I've gone over last night or this morning that would suggest an outright short position is in order. The kind of thrust we saw yesterday is highly unusual, and on top of that the S&P 500 scored a clear breakout that should excite traders and investors alike that were looking for some kind of price confirmation of the August low, so I have no intention of trying to step in front of this market right now.

We usually see either moderate positive or outright negative returns in the few days after moves like yesterday, and our short-term guides should be fully overbought later today if the opening gap sticks and we see even a small amount of follow-through. That, too, would conspire to limit any further gains when looking out over the next few days.

Overall, things continue to look swell from an intermediate-term standpoint, and I don't see any reason for those long in that time frame to consider significantly changing their position. Short-term, things are a lot more tricky - more often than not it doesn't pay a whole lot to chase prices after a move like we just saw. It's always tough to stomach the taunts from those who were long and leveraged (and gambling) heading into the Fed announcement, but my approach is to be patient and wait for high-probability setups that tend to occur several times a month, and try to take advantage of them when they occur. That helps to generate consistent, relatively low-volatility returns no matter the overall market environment, and that's what really adds up over time. And right now, in the short-term only, there doesn't seem to be much that's high-probability in what I'm seeing.

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