Snapshot Notes - October 10, 2007

As of:

SPX 1523

Over the years, we've looked at many divergences of one kind or another. Whether it was how indexes performed against each other, or their component stocks, or breadth or even sentiment, there has often been a nugget of useful information when something doesn't act as expected.

This week we've had the opportunity to go over a couple of them, those being the advance/decline line on the NYSE versus the S&P 500, and Semiconductor stocks versus the Nasdaq 100.

Both divergences were moderately consistent in preceding market weakness going forward, but not consistent enough to suggest that a top is imminent. With much of what we've looked at this week, the most likely scenario seemed to point to period of choppy swings at best.

Another factor pointing in that direction (or lack of direction) comes from the latest Investor's Intelligence sentiment survey, which showed more than 60% of respondents betting on more upside for the market. That was the most lopsided amount of positive opinion in nearly two years, and one of the highest amounts of the past decade.

In the past when we've seen this near-universal optimism, aggressive bulls have not been rewarded. Prices have either declined over the next several weeks (or months) or went into an environment where neither rallies nor pullbacks were long-lived.

In August, we had a multitude of studies that all pointed to the same thing - a rally of 10% to 20% in the S&P 500 over the next one to three months. Now we're seeing that risk/reward suddenly shift to a period where the risk seems about equal to the probable reward, whether one is either long or short. That is a notable change from what we've been seeing, and I'm toning down my intermediate-term expectations accordingly.

On a shorter-term basis this has been an exceptionally challenging market if looking for high-probability entries on the long side, but I think we'll see better opportunities if the longer-term studies we looked at are correct and we're about to enter a much choppier period. That means deeper pullbacks that last longer than one day, and it should allow us to better navigate some of these short-term swings.

As of:

SPX 1523

HELP ARCHIVE

Earlier today, I touched on the divergence we were seeing between some tech indices like the Nasdaq 100, and the Semiconductor sector.

That divergence is taking on renew life today, with the Nasdaq 100 Trust (QQQQ) showing a positive return on the day while the Semiconductor HOLDR (SMH) is down by more than 1%.

There have been three other times in the history of those two funds when SMH was down more than 1% on the day while QQQQ managed to struggle to a higher close, a day after the NDX had hit a 52-week high. Those three occurrences (06/12/03, 11/21/06 and 04/27/07) did precede a short-term peak in momentum for the NDX, but not much more than that. The NDX chopped around for a couple of weeks after each of those instances, not going much of anywhere to the upside or downside, before resuming its rally.

That prognosis for choppier conditions seems to be recurring more and more frequently in the different studies we've been going over, whether it's from the Nasdaq/NYSE Volume Ratio or the recent extremes in a couple of the sentiment surveys.

But so far traders are having none of that, as the indices are again recovering from a very minor intraday pullback and the NDX is hitting yet another new high. I think this is unlikely to continue, and I expect those choppy conditions to set in, especially as we approach the heart of earnings season.

That doesn't mean I want to short - I still see little edge in trying to do that - but a continued attitude of looking selectively for solid long entries should pay off, and it's what I'm trying to be patient enough to find. The past few weeks have not rewarded patience whatsoever, though, which is frustrating to the nth degree. Of course, about the time I think the only way to go is to buy every new high, is the precise time the momentum will stop, so I'm not going to throw caution to the wind...as hard as it is to see this constant momentum.

As of:

SPX 1523

HELP ARCHIVE

Good Wednesday morning...we begin the day with some slight weakness in the pre-market futures as we unofficially kick off the earnings season with Alcoa. Be prepared for the risk of gap openings during the next few weeks as earnings hit the tape in earnest.

In August, we discussed the Investor's Intelligence sentiment survey a few times, making careful note about how bearish the newsletter writers in that poll had become. That was highly unusual, since as a group they tend to tilt to the bullish side on a consistent basis.

I'm sure they've heard loud and clear from their subscribers about being bearish, especially as the market has done nothing but rally since then. Well, a great number of those letters have suddenly seen the light, and an overwhelming percentage of them are now all-out bullish.

For the latest week, Investor's Intelligence is reporting that more than 60% of their respondents expected a further rally out of stocks. That's the most since December 2005 and it qualifies as one of the very highest readings in the past decade. That's quite a switch from a month and a half ago.

There have been 8 other weeks since the bull market began in the fall of 2002 when the percentage of bulls in this survey have galloped over 60%. Two weeks later, the S&P 500 was positive 3 of those times and it showed an overall average return of -0.3%. A month later, it was still 3 for 8, but the return slipped to -0.9%, and the most the S&P was able to gain during the months (on average) was +1.7% compared to an average drawdown (i.e. maximum loss) of -2.5%.

As I mentioned last week with the AAII survey, and yesterday with the Nasdaq/NYSE Volume Ratio, when we reach these types of excessive bullishness readings within a strong uptrend, they don't necessarily precede an imminent top, but they have been consistent in highlighting those times when we either do see a decline, or at best a period where the uptrend becomes much more choppy.

Earlier this week, we went over the divergence between the S&P 500, which was hitting a new high, and the NYSE advance/decline line, which was lagging behind. We also have another interesting divergence, this one between the Semiconductor sector and the broader tech indices.

Specifically, the Nasdaq 100 index has hit a new high while the Semiconductor HOLDR (SMH) is more than 5% below its own high. The last time this occurred was May of this year, which wasn't a bad time to be long except for some short-term chop.

Over the past few years, it has been a little less benign, with the Nasdaq 100 showing a one-month average return of -0.3% and 46% with a positive return. The three-month return in the NDX was -1.3% and the percentage of positive days dropped down to 37%. The maximum amount the NDX was able to rally during the three months averaged +3.8% while its average drawdown was -5.6%.

From an intermediate-term standpoint, I've been pretty adamant that the risk/reward clearly and substantially favored the upside. That has changed and at this point they're equal at best according to some of the readings that are beginning to register. Prices still haven't done a single thing "wrong" since the August low, so it seems very early to try anticipating a meaningful fall here, but the risk has absolutely increased this week compared to the likely reward of higher prices when looking over the next few weeks and months.

As for the short-term, several of our more sensitive indicators were suggesting oversold conditions by Monday afternoon, a relatively odd development given the very modest pullback in price. As strong markets do, prices jumped higher soon thereafter and most of those guides are back to neutral or moderate overbought readings.

This remains an exceptionally challenging market if looking for high-probability entries on the long side, but I think we'll see better opportunities if the longer-term stuff we look at is correct and we're about to enter a much choppier period. That means deeper pullbacks that last longer than one day, and it should allow us to better navigate some of these short-term swings.

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