Snapshot Notes - October 17, 2007

As of:

SPX 1550

This morning, I mentioned that I hate seeing gap up openings in the direction of my trade, and today is yet another example of why that is the case. Large gap openings have the potential to significantly change the dynamics of the market in a very short period of time.

Earlier, we went over some various stats regarding this morning's gap, and none of them were good. They all pointed to the likelihood of a close that was lower than the open, and barring a fabulous late-day recovery it looks like today is going to go along with those precedents.

When we've seen a large gap up then downside intraday reversal like today, the returns going forward were mixed in the short-term. I could find nothing particularly bullish or bearish about it.

Something that has caught my eye, however, is that three scant days ago, the S&P 500 was within a whisper of a 52-week high, then closed lower by at least 0.5% for two consecutive days and lost as much as 0.5% today.

I checked the history of the index for any other comparisons, and came up with 25 of them. Over the next week, the S&P showed a positive return 18 times (72%) with an average return of +1.0%. Of the winning trades, most of the time (11 out of 18) the S&P didn't drop any more than an additional 0.5% at any point during the next week, and they managed to rally a maximum of +2.7% on average. Of the losing trades, the vast majority of time the S&P didn't gain any more than +1% during the next week. What that means now is that if we see the S&P drop any more than 0.5% over the next week, we should perhaps dim our expectations for further rally attempts.

I've looked at the past three days from a number of different views (price patterns, option expiration, breadth and sentiment) and most of the studies turned up positive results over the next 3-5 days about 70% of the time.

That is similar to what we were going over yesterday, and yet we're seeing another down day - again, this is why I hate gap openings and why I sold some at the open. During earnings season, this is just something we have to deal with on a day-by-day basis.

Stiff pullbacks from recent highs tend to lead to consistently positive results, with action like July being the outlier, so I'm still moderately positive on the short-term as we head into option expiration. There are absolutely some longer-term concerns that aren't going to be so quickly resolved (such as the excessive bullishness from several of our indicators, and the fact that the indices have reacted so poorly to yesterday's short-term oversold signals), but for a trade I still think the risk/reward is moderately positive for now.

As of:

SPX 1550

HELP ARCHIVE

Good Wednesday morning...we begin the day with something we're going to have to prepare more for - gaps up in the morning based on overnight or early-morning earnings releases. This morning we face a large gap up as INTC and YHOO beat expectations.

Since 1995, whenever Intel (INTC) has gapped up 4% or more during earnings season (whether it was directly related to their earnings or not), we've also seen the Nasdaq 100 (NDX) gap up 100% of the time (24 out of 24), by an average of +2.9%. Most of those were during the final stages of the bull market when volatility was much higher than we've seen the past few years - in fact the last occurrence was in October 2003.

Like usual, however, buying into those gaps wasn't often a good idea. The NDX closed higher than the open only 9 times (38%), with an overall average return of -1.0%. On average, the most that the NDX gained intraday was +1.8% compared to an average drawdown (i.e. maximum loss of -3.0%).

This has happened four times since 2003, and the NDX closed lower than the open all four times by an average of -2.0%, gaining at most +0.3% from the open. Waiting until the close and holding for the short-term was at best a 50/50 proposition, but it was much better than buying the gap up open and holding.

Forgetting about INTC for a moment, let's just look at any time the NDX has gapped up more than 1% on any day since the bear market low in 2002 (using the QQQQ tracking fund as a proxy for the index). Out of 49 occurrences, it managed to close higher than the open 17 times (35%), losing -.3% on average, though the average maximum gain seen during the day (+1.2%) was fairly close to the average drawdown (-1.5%). Looking at this large of a gap up open, but only during Octobers, gave similar results.

Another piece of alarming data this morning comes from the Investor's Intelligence sentiment survey, which showed 62% of respondents as being bullish on the market's prospects - the most since December 2004. Prior to that, we'd have to go all the way back to 1987 to find another week with this extreme of a reading.

I know, I know...1987. But it's very important to note that this extreme reading in the bullish percentage occurred in January of that year, and the S&P 500 went on to gain more than 25% during the next six months before crashing. In fact, since 1969, the three-month return in the S&P when the bulls got this high averaged +1.2% with 55% of them showing a positive return.

So looking at recent history, such a lopsided number of folks on the bullish side does not look encouraging, and I do believe that it is a negative factor for stock prices. However, it is not a "crash" signal, and we could see stocks continue to stagger higher for weeks or months before this kind of excessive optimism will be punished. We need to keep on our toes, but there is little sense in hiding in a cave just because a little over 100 newsletters expect the market to keep rising.

Heading into the open, the indices look prepared to erase yesterday's losses (and Monday's, too, in the case of the NDX). I've been looking for an overall positive bias for the short-term, but like I've been noting, during earnings season we're going to have to deal with a good number of gap up openings. I do not like to see large gaps up when I'm expecting prices to rise.

I know that sounds like twisted logic (why in the world wouldn't I want prices to gap in my favor?), but as we saw from the stats above, the market has had a difficult time gaining ground when we see large gaps up in the morning. I'm going to dim my expectations a bit for the day based on this large gap up, assuming we "open" at around 1550 in the cash S&P 500 index. If we can hold at or above the opening prices during the first hour, then there should be less chance for a negative reversal, so we'll just have to see how traders react to this situation.

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