Snapshot Notes - October 12, 2007

As of:

SPX 1523

My wife and I have been struggling to find a way to instill in our boys some lessons that we've been failing to teach them at home - mostly respect towards each other, and all-around discipline. It's not that they're out of control, but man I don't ever remember acting the way they do sometimes.

Something that they've taken to, and which seems to be working, is karate lessons. What made us gravitate to this particular dojo is something the instructors refer to as CARRD. It stands for Control, Attitude, Respect, Responsibility and Discipline. The students cannot advance and get their next belt until they show a mastery of CARRD.

It's interesting how that acronym is perfect for anyone trying to trade as well:

Maintain a positive Attitude - you can effectively manage your positions over time

Discipline is the most important element - lack it, and you will pay the price one day

I've been trying to practice the "D" over the past few weeks, and I make no bones about the fact that it has hurt. This is not a market that has rewarded discipline, at least in terms of those not already long and holding.

Things may be starting to make a little bit more sense, at least in terms of how prices are acting compared to how they have in the past under similar circumstances.

For example, yesterday and this morning we discussed the recent patterns in the S&P 500 and Nasdaq 100, mostly related to yesterday's gap open and big reversal. Going forward, the precedents were pretty consistent, and so far the indices have responded right in line with those historical precedents.

I don't want to get too glued to those templates (there is always a big dose of luck involved), but today's trading unfolded similarly to those others. If we stay true to form, then we should expect today to be something of a one-day wonder, with more selling pressure due early next week.

Next week we also have option expiration, which has had an overall bullish tilt during the past year, with 10 of the past 12 showing a positive return averaging +0.7%. Other than this past August, the drawdown during the week has been modest, averaging -0.8% (excluding August), while the maximum gain during the week has averaged +1.5%. That's a fairly positive edge, but it breaks down when looking back any further than the past year and I'm not relying too heavily on those results.

Some of our short-term guides have given oversold signals for both the S&P and NDX since yesterday afternoon, which was pretty good support to the idea of a reflexive bounce today. Perhaps this will play out like the other recent oversold signals, and we'll just continue to take off to the upside, but I think that's unlikely. I'm intrigued enough by the pattern of the past couple days, and their consistency going forward, that I think it's more likely that we'll see more pressure early next week, and I'm relying on that to give a better long-side opportunity than what we see here.

The latest Commitments of Traders data, released late this afternoon and including positions as of this past Tuesday, showed that commercial hedgers (aka the "smart money") had reduced their net long positions again, marking the third week in a row that we've seen them reduce their positions. The end result is that they're still net long by approximately $16 billion, and it's still nowhere near earlier this year when they were $40 billion to the short side.

Also, small speculators (aka the "dumb money") showed a change in their net long position, from around $9 billion to just over $12 billion. That's just a minor adjustment when considering that their net position earlier this year was over $27 billion, so we have a ways to go before we could consider this a negative for equities.

As of:

SPX 1523

HELP ARCHIVE

Yesterday and this morning we discussed the recent patterns in the S&P 500 and Nasdaq 100, mostly related to yesterday's big reversal. Going forward, the precedents were pretty consistent in that they preceded a quick (one-day) bounce, then more weakness in the couple of days following that.

I don't want to get too glued to those templates, but so far today's trading is playing out closely to those others. Two of them were able to completely reverse the losses from the day before, but still suffered weakness in the couple of days going forward, so today's impressive bounce still isn't all that unusual compared to those.

In fact, as we went over yesterday, the average next-day return in the NDX after those prior reversals was +1.8%, and we're not far from that today. In any event, if we stay true to form, then we should expect today to be something of a one-day wonder, with more selling pressure due early next week.

Next week we also have option expiration. Over the past year, the week of expiration has had an overall bullish tilt, with 10 of the past 12 showing a positive return averaging +0.7%. Other than this past August, the drawdown during the week has been modest, averaging -0.8% (excluding August), while the maximum gain during the week has averaged +1.5%.

I think too much is made out of the seasonality around option expiration, other than consistent weakness immediately following expiration week, which we saw again last month. However, October has kicked that pattern in the teeth, with the day following expiration showing a positive return 10 out of the last 10 years, averaging just under 1% each time. We have a week before we need to worry about that, though, and other than that I don't see much of a potential edge surrounding expiry.

Some of our short-term guides have given, or are close to giving, oversold signals for both the S&P and NDX, which was pretty good support to the idea of a reflexive bounce today. Perhaps this will play out like the other recent oversold signals, and we'll just continue to take off to the upside, but I think that's unlikely. I'm intrigued enough by the pattern of the past couple days, and their consistency going forward, that I think it's more likely that we'll see more pressure early next week, and I'm relying on that to give a better long-side opportunity than what we see here.

For those curious about the Semiconductor HOLDR (SMH), which opened down a couple of percent from yesterday's close despite the component stocks opening mostly higher, the difference is due to the de-listing of Maxim (MXIM), one of the component stocks in SMH. Because of the way HOLDRs are constructed, the same component stocks are always in the fund until the fund closes. So now that one of the component stocks is no longer trading, the fund had to make an adjustment to its value. You can use the SOX index as a proxy for the sector instead of SMH to get a better read on today's trading.

As of:

SPX 1523

HELP ARCHIVE

Good Friday morning...we begin the final day of the week with some minor follow-through to yesterday afternoon's rebound attempt, though we have the important sectors of Banks, Brokers, Retail and Semiconductors all lagging badly.

Yesterday morning, we went over some stats related to the gap up in the Nasdaq 100 (NDX) that ended up playing out quite well. There is always a healthy dose of luck involved when that happens, so we shouldn't get too wrapped up in assuming that the market will continue trading in the same manner as those precedents, but they were pretty consistent in that often we saw a bounce-back the next day.

I went over another pattern that triggered yesterday as well, this one relating to the fact that the NDX hit a new yearly high intraday, then fell back enough to close below the low of the past three trading days. While it's only happened five other times in the history of that index, we did see it bounce back the next day four of the five times.

However, buying the next day's close (today's close in our current situation) and holding for a couple of days led to negative returns all five times. On average, the most that the NDX was able to gain during the next couple of sessions was +0.6%, while the average drawdown (i.e. maximum loss) was a gut-wrenching -3.1%. For those curious, the dates of the big negative reversals were 06/06/96, 07/21/98, 11/30/98, 01/24/00 and 06/20/07. Two of them led to intermediate-term declines, while three of them preceded excellent buying opportunities.

It's tough to read a lot into only five occurrences, so if we relax the parameters a bit and look at those times the NDX reversed from a high to close below the prior two days' lows (instead of three days), then we get 11 instances. The NDX rebounded the next day 8 times, and then buying that close and holding for a couple of days led to a positive return only 4 times.

We also had a "key reversal" in the S&P 500, with than index hitting a new high intraday, then closing below the prior day's low. The next-day rebound wasn't in effect there, at least during the past decade, as the following day closed in positive territory less than 40% of the time.

And again, buying the next day's close and holding for a couple of days led to a positive return only 37% of the time. The maximum gain over that span of +0.6% was dwarfed by the average drawdown of -1.2%, about twice as great. Mostly, though, these did not lead to longer-term market tops - the S&P was positive a month later 63% of the time, and three months later more than 75% of the time.

So there may be something of a template here that we should consider - perhaps a quick rebound in the very short-term, then more selling pressure over the next couple of days. After that, whether yesterday leads to a more lasting decline or a resumption of the rally is pretty much up for grabs, at least according to this particular price pattern.

Supportive of a short-term rebound are the more sensitive guides that we follow, which cycled towards oversold territory, at least the ones for the Nasdaq 100. From the data above, there was a moderately consistent tendency to see some short-term upside following reversals like yesterday, but it was just as consistent to see weakness in the days following that.

So my take on this is that if trying to buy for a rebound, we should be quick-fingered in that respect, since it seems more likely than not that we'll see selling pressure in the days to come that trump whatever rebound we see in the very short-term. After a couple of days, though, the bias actually turns positive, and if we hit some oversold readings in that time, which seems likely, then it should give us a decent opportunity on the long side.

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