Snapshot Notes - October 2, 2007

One of the frustrating parts of watching this market over the past couple of weeks has been the rotation among sectors. When we have laggards become leaders and vice-versa, it usually results in choppy trading in the broad indices, and the past week or so has been a good example of that.

Today was a case in point, with struggling sectors like Housing, Retail and Financials taking the lead while erstwhile leaders like Technology taking a back seat. It was also small-caps' time to shine, as the Russell 2000 index was up more than 0.75% while the S&P 500, DJIA and Nasdaq 100 were all negative on the day.

Coming off a day like yesterday, such rotation into small caps might be considered a healthy movement of funds into riskier assets. To check, I looked for any other time in the past decade where the S&P 500 was up 1% or more the previous day, then today the Russell 2000 was up more than 0.75% while the S&P, Dow and NDX were all down.

The only occurrence that popped up was June 30, 2006, which didn't prove to be so healthy as the S&P ended up losing about 3% over the next few weeks. We can't read much into one precedent, so I loosened the parameters a bit and only required the Russell to up 0.5% or more on the day while the other three closed in negative territory.

That brought up 9 instances, and again it didn't seem so bright. A couple of weeks later, the S&P was positive only 2 of the 9 times and it showed an average return of -0.8%.

I was kind of hoping to get away from anything seasonality-related after stressing it so heavily last week, but this morning I had to relapse and go over some figures that were too consistent to ignore. A subscriber had asked about October's performance during years ending in "7", and I showed a table that gave the results going back to 1897.

Those results were very consistent and stunningly bad for equities. Averaged over the 11 occurrences, October's maximum gain was a pathetic +0.7% compared to an average drawdown of -12.0%. A risk/reward ratio that skewed is hard to find when looking at seasonal statistics.

In addition to that potential negative, we've starting seen a few signs of "dumb money" speculation. Our Rydex Beta Chase Index spiked up yesterday, telling us that those traders were 10 times more likely to buy into a risky fund than a safe one. Combined with a jump in Odd Lot Purchases and some other measures, it appears as though the recent recovery has started to pique the greed of the individual investor.

Even so, I'm not too hip on trying to short this market without first seeing some signs of actual price failures. As we saw in the fourth quarter of last year, sentiment can get trumped by a strong price trend, and I have no desire to get caught up in that kind of thing. About the only way I'd take a shot on the short side is if we see a failure of 1540 in the cash S&P 500 index, then a weak rally back up to that point.

In the meantime, I'm on the lookout for high-probability attempts at the long side, and I'm not seeing one now for the reasons mentioned above.

Despite a further recovery in the down-and-out Housing, Retail and Financial sectors, the broader equity indices have done nothing but tread water today.

That's not necessarily good or bad, it just "is", and it's left the S&P 500 cash index dangling between yesterday's breakout of 1540 below and its old high of 1555 above. The connotations of a move outside of either level are obvious - a move below 1540 will usher in the "false breakout" chatter, while a move over 1555 will be confirmation of the Dow and Nasdaq's impressive moves.

I still don't see much edge either way for the short-term. This morning, I went over a bit of scary October seasonality and some too-enthusiastic readings from some of our "dumb money" indicators. Those aren't enough to get me to consider short sales in a tape like this, but it also makes long entries tough to stomach, so I'm standing pat and keeping idle - not the best feeling if we continue to rip higher, but the only way to stick with my discipline.

Until we get some movement among our indicators and/or a move outside of the zone mentioned above in the S&P, I'm doing nothing here trading-wise.

Good Tuesday morning...we begin the day with slightly positive pre-market futures, at least so far, as takeover activity in the banking sector helps sentiment recover in that lagging group. If financials catch fire to the upside, then we will be seeing new highs in all the major sectors in short order.

I thought I could get away from looking at seasonality for awhile, but a subscriber asked me to take a look at something this morning that caught my eye. She wanted to see returns during the month of October (after the first couple of days had passed), but only during years ending in "7".

I'm always leery of these kinds of studies, but I took a look anyway. I have to admit to being a little bit intrigued by the results, shown in the table below:

YEAR	RETURN	MAX GAIN	MAX LOSS
1897	-7.7%	+0.0%	-8.1%
1907	-14.2%	+0.0%	-14.4%
1917	-7.5%	+0.0%	-8.9%
1927	-8.7%	+0.2%	-9.6%
1937	-11.2%	+0.0%	-17.4%
1947	+2.1%	+3.2%	-0.4%
1957	-5.3%	+0.0%	-9.9%
1967	-5.9%	+1.3%	-5.9%
1977	-4.4%	+1.0%	-5.3%
1987	-23.7%	+0.0%	-38.8%
1997	-7.4%	+2.2%	-13.7%
Average	-8.5%	+0.7%	-12.0%

As we can see, the returns were stunningly bad. Only one of the 11 instances going back to 1897 was positive in the Dow Jones Industrial Average. On average, the maximum gain seen during the month was a downright pathetic +0.7%, and only two of them showed a max gain of more than +2%. The average drawdown, however, was a monstrous -12.0%, with all but one year showing a loss of at least -5%.

Some analysts swear by a 10-year cycle, but history is too short to make that claim significant. If we pick any one month from any one digit-ending year, then it's possible that'd we'd find an outstanding phenomenon simply by chance. Why would October from a "7" year by any different? Something to do with election cycles and fourth-quarter seasonality? If so, then there could be something to this pattern.

As it stands, I'm not totally convinced that this is anything other than happenstance, but I have to admit to pausing after seeing how consistent this has been. The Dow has already rallied 1.4% this month, so in one day it has surpassed the maximum gain seen during 9 of the 11 previous occurrences. If we begin to see a confluence of overly optimistic readings, though, or a "false" breakout in price, then perhaps it would be best to remember this little study.

Speaking of overly optimistic readings, those are starting to add up (no surprise given the recent run higher). Our more sensitive guides are mostly neutral, but we're seeing exceptionally optimistic readings from things like the Rydex Beta Chase Index. That index looks at how eager traders of the Rydex mutual funds are to get into high-risk funds as opposed to "safer", lower-beta ones.

Last night, that Index closed with a reading just under 10, basically meaning that they were 10 times more willing to buy a risky fund than a safe one. We haven't seen that kind of speculation since July 3, 2006, after which the market went into a two-week funk. In the seven-year history of the indicator, the future 10-day return in the S&P after Index readings approaching this kind of extreme have been -0.1% with 40% of them positive. Not horrible, but significantly worse than random.

Also among the "dumb money", we've seen a spike in Odd Lot Purchases, and a drop-off in Short Sales, not to mention a renewed interest in trading individual equities as opposed to ETFs, as shown by rapidly shrinking Liquidity Premiums.

Those are all reasons enough for concern, but as far as I'm concerned, they're not strong enough to suggest trying to short into a market like this. As we saw in the fourth quarter last year, extreme sentiment can be trumped by a strong trend, and we can grind higher for weeks on end. That makes for exceptionally tricky trading for anyone but faithful buy-and-holders that are lucky enough to get out before the gains are erased by one of the multitude of swift panic attacks we've seen.

So we do have relatively overbought conditions during what may be a tough seasonal month, at least according to the table above. Instead of shorting, though, I am going to continue to be hyper-selective with short-term long-side trades. About the only way I'd consider a short at this point is if we quickly see a rejection of yesterday's breakouts, then a meager rally attempt back towards the breakout levels. There are a lot of "ifs" there, so a short isn't really on my radar at this point.

If we continue to ramp higher, then it will of course be exceedingly frustrating for short-term accounts. But I continue to believe that if we can be selective and take multiple high-probability chunks out of these moves, then over time it adds up to significant yearly returns with less risk, and less dependence on the market environment, than just buying blindly and hoping for the best. I'm still flat in trading accounts here and I don't anticipate an imminent change in status.

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