Snapshot Notes - October 19, 2007

As of:

SPX 1501

Well, that was the ugliest anniversary since the 50th celebration of my single-toothed grandfather and hairless grandma. Loved 'em both, but they weren't much to look at.

The anniversary to which I'm referring, of course, is the crash of 1987, which we've heard bandied about constantly leading up to this week, and today's action will give the weekend news editors wet dreams as they pontificate their headlines.

By Tuesday of this week, we got a confluence of readings among our more sensitive guides that suggested prices had come down too far, too fast. Those kinds of oversold readings have been consistent in leading to a short-term rebound since the August low.

When we got the large gap up on Wednesday morning, however, that changed the dynamics of our setup. I showed at the time how the major equity averages have struggled after those types of gaps, and again that proved to be the case as we saw steady selling pressure throughout Wednesday. What's different about this time is that we didn't get any more of a bounce after Wednesday's close. Despite being short-term oversold and some moderate positive seasonality, prices weren't able to rebound.

That is not only a change in character from what we had been seeing, it is a troubling hallmark of weak markets. This is doubly curious since in the week prior, we had gone over numerous examples of excessive optimism among our longer-term indicators. From small options traders to newsletter writers to Rydex traders, there were more and more indications of speculation popping up.

When that happens, it's rare to see a continuation of a steady uptrend. Much more common is either an outright decline, or a much more volatile move higher. What we've seen this week certainly reinforces that, and it should continue until some of this speculation is wrung out.

For the very short-term, we have again reached a severe oversold condition. Even during down-trending markets, when we reach this type of extreme there is usually something of a bounce, at least over a period of several sessions. When we put it in the context of a longer-term uptrend, during one of the most seasonally positive times of the year, then that helps the probability of a bounce.

We also have the BKX banking index and RLX retail index showing negative daily returns for the past eight days. That is a nearly-unprecedented amount of selling pressure, at least over the past 15 years or so, and the few times it has approached this number of days, both indexes have rallied in the short-term every time.

There are definitely longer-term concerns at this point, namely the lack of a bounce this week, the signs of excessive optimism and even the odd breadth divergences like we went over this morning (i.e. the triggering of a "Hindenberg Omen") that have been consistent in preceding market weakness. That does not necessarily preclude short-term rallies, though.

The latest Commitments of Traders report, released late this afternoon and including positions as of this past Tuesday, showed that large commercial hedgers (aka the "smart money") reducing their net long exposure again, this week down to $8 billion. This remains historically extreme, but much less than the record of $40+ billion from a couple of months ago.

The "dumb money" small speculators have done the opposite, increasing their net long exposure during the week. They're now up to $17 billion from just $9 billion last month, and are back to what I would consider neutral territory from an earlier bout of what appeared to be extreme pessimism.

As of:

SPX 1501

HELP ARCHIVE

Just a quick note to say that I'm stepping up my buying a bit before the close. I'll have more after the bell, but there's nothing much new as far as the reasons for upping my exposure for a trade. I still think we've uncovered some longer-term serious issues this week, but for the near-term we should get a snapback from pressure like this.

As of:

SPX 1517

HELP ARCHIVE

There has been some stiff selling pressure today, and comparisons to 1987 are beginning to heat up.

The similarity that sticks out to me is that there have only been three times since index options were introduced when the S&P 500 lost 2% or more heading into an October options expiration. Those were 1987, 1997 and 1999.

1987 we all know about, as the market crashed the following Monday. 1997 wasn't quite the same, as the indices bounced for two days following expiration, then tumbled nearly 10% over the next week. 1999 was totally different, as we got a little dip the next Monday then took off on a huge rally.

Crashes notwithstanding, when we get these types of oversold readings during the fourth quarter, it has been a pretty safe bet to try the long side. I checked for any time that the 3-day Relative Strength Index (RSI), one of the very few technical indicators I use, was below 10 on the S&P 500 exchange-traded fund (SPY) during October, November or December. Buying that close and holding for three days resulted in 10 winning trades out of 12 attempts with an average return of +1.5% (the two losers were -0.1% and -0.6%).

Our shortest-term guides are confirming the oversold nature of the RSI, though as we know, short-term oversold conditions haven't been the best tell this week. We got a quick gap up open on Wednesday after some oversold readings on Tuesday, but other than that we have not seen any sustained upside.

That's not a good sign for the intermediate-term, particularly in the context of the other negatives I went over this morning, so I don't want to be overly aggressive buying oversold conditions. I still think it makes sense to try something - we are still in a defined uptrend during the seasonally best time of the year after all - so I'm adding back a bit here.

I admit that the comparison to 1987 is striking in many respects (and totally different in others), and perhaps that will be enough to keep buyers at bay until and unless we happen to see some recovery early next week that shakes the sense of doom out there right now. But given these oversold readings and the short-term results that tend to follow, and the likelihood that we could see at least a temporary snapback in banking shares based on the data I went over this morning, I'm going to try another small stab at the long side.

As of:

SPX 1538

HELP ARCHIVE

Good Friday morning...we begin the day with weakness across the board, as Google's earnings were not enough to push us higher. This is something I mentioned yesterday as a risk I did not want to take. The losers among the major sectors I watch are numerous, with the majority of them showing losses greater than 1%, including the important financials.

The banking sector is severely oversold at this point. The BKX Banking Index has closed in negative territory for seven consecutive days, the first time since the July 2002 low that it has done so. Over the 14 years of history I have for that index, I show that this has happened four times other than the current one.

The 10-day return going forward was positive all four times with an average return of +3.2%. The maximum gain during the next two weeks averaged +7.2% compared to an average drawdown (i.e. maximum loss) of -4.3%. Here are the dates: 09/21/93, 08/05/99, 06/14/01, 07/22/02.

We get somewhat similar results when looking at the hugely negative 10-day rate of return in that index (it has dropped about 7% in the past two weeks), and with that index testing its August lows, I'm starting to look for a bounce from that group - not necessarily a major low, but at least a bounce.

If banks do bounce, then that would almost certainly help prop up the broader market, which seems in dire need of some propping up. Earlier this week, we went over a handful of short-term positives, but those were mostly sucked up in Wednesday's gap up open. We've done nothing but flop around since getting some short-term oversold signals a few days ago, and that is not typical behavior during strong, healthy up-trends.

What makes this more disturbing to me is that this loss of momentum is coming on the heels of a battering of "excessive optimism" readings from some of our more intermediate-term indicators. We've gone over examples ranging from small options traders to newsletter writers to Rydex traders, all showing extreme readings.

I'd like to touch on another potential negative, simply because it is getting quite a bit of attention. It is called the Hindenberg Omen, and it's something I've written about several times in the past. This market crash signal is generated when there is a big split in the market, with at least 2.2% of all stocks traded on the NYSE hitting a new 52-week high, and another 2.2% (or more) hitting a fresh 52-week low. There are some other parameters involved to validate the signal.

I have some issues with data like this because it crosses the border into data-mining. Give me enough computer power, and I'll find a combination of indicators that has predicted 100% of the market crashes...but t would be meaningless going forward.

The thing with the Hindenberg Omen is that it has been around, in real-time trading, for decades, and has continued to have a moderate-to-good success ratio at preceding market weakness. The last time we got two consecutive days with a Hindenberg Omen (we got three in a row this week, by the way) was July 23rd of this year, which was obviously an excellent sell signal.

Going back to 1965 and looking for any unique period when we had two straight days with a Hindenberg Omen, I can find 20 occurrences. Returns going forward were modestly weak in the short-term, up to 10 days later, but became successively weaker as we go further out, up to three months later.

Looking at those three-month returns, the S&P 500 was positive only 6 of the 20 times (30%), with an overall average return of -1.9%. The maximum gain during those months averaged +4.9% compared to an average drawdown of -8.7%. There were two big failures, in October 1995 and January 1998, but other than those two one would have been well-advised to exercise caution after these signals. The max loss / max gain ratio without those two instances was 3-to-1.

Again, I have some trouble staking an investment outlook on this signal because of its origination and the various rules surrounding it, but it has proved itself over time to be successful at highlighting periods of questionable market performance. It's another thing to add to the other potential negatives we've discussed.

Yesterday afternoon I mentioned that I was pulling back from trading positions, based on our inability to rally from the short-term oversold conditions earlier in the week and the other various negatives. I'm still looking to buy into oversold conditions, but I also want to be a more aggressive seller of overbought ones. Currently, in the short-term, we have neither and I am standing pat, waiting for the next possible opportunity.

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