Snapshot Notes - October 22, 2007

As of:

SPX 1501

Large gap openings have a habit of marking the height of emotional trading, and so it's no surprise that they often also mark at least short-term exhaustion points.

We saw that last week with a gap up, and possibly again today with the opposite condition. I noted this morning that in the past when we've seen such a gap down opening, after the kind of performance we saw last week, then we consistently got at least a short-term snapback even during the worst of the bear market.

When stocks had been in an uptrend at the time (defined as a rising 200-day moving average), then over the past 20 years this kind of setup has led to robust positive results. With only one exception (and it was a major exception...just prior to the '87 crash), the S&P 500 turned in very lopsidedly positive returns after sell-offs like last week and gaps like this morning.

So I was looking for at least a short-term rebound here, and possibly more. What's holding me back a bit on an intermediate-term time frame is the abundance of indicators we saw leading up to last week that showed us how much excessive optimism was out there. We often get sub-par results over the intermediate-term when traders become that lopsidedly bullish.

It seems to me that we should see a very choppy market that would be good for short-term swings in both directions. That means I want to be a buyer of short-term oversold conditions and seller of short-term overbought ones. Given that we're trying to emerge from the former, I'm still looking for more of a recovery here. We're going to be held hostage to reactions to earnings news, mostly focused on Apple tonight, but that's the way it goes four times each year. So far the reaction to AAPL seems encouraging, but it's important to note that that particular stock has a habit of gapping up after an earnings release, then trailing off once regular trading begins the next day. If it helps to create a gap up opening in the broader market tomorrow, then I'll have to consider selling some of what I bought Friday afternoon.

As of:

SPX 1501

HELP ARCHIVE

We've had a decent rebound from the opening gap as the indices try to stabilize after Friday's mini-panic.

I've tried to find any other edge with regard to today's trading, but can't find much to work with here. Our shortest-term indicators have cycled out of severe oversold territory and are mostly neutral at this point, and the price patterns seem relatively neutral.

I did touch on something this morning with regard to the price action of the past week, and that is still in effect. Typically we get a two-three day bounce after behavior like last week and this morning, even during severe downtrends. When we add in the fact that the S&P 500 is still in a long-term uptrend, then nearly all the prior instances I've found led to positive short- and intermediate-term returns (excluding one right before the '87 crash).

I'm still banking on that to carry through this time. We have earnings from Apple on tap after the close, and as we saw last week, these big tech names can have an outsized impact on pre-market trading, so anyone taking positions overnight had better factor that into their risk profile. I don't like to be overly aggressive with any short-term positions during the heat of earnings season, and this is no exception, so I'm just going to carry what I have and see what kind of reaction we get to earnings after the close.

As of:

SPX 1501

HELP ARCHIVE

Good Monday morning...we begin the new week with some serious selling pressure in the major indices, as foreign markets were down significantly and we're operating in a "sell first, ask questions later" kind of environment.

Large gap down opens after a week when we already had heavy selling pressure tend to be exhaustive events, marking short-term capitulation points more than continuations.

Over the past 20 years (using S&P 500 futures prior to 1995, and the SPY exchange-traded fund from 1995-present), I show 33 instances of the S&P gapping down at least -0.50% on a morning after at least a 1% loss the day before and a 4% loss during the prior week. The indices could recover before the open, but we have to deal with what we have at the moment. For all the stats below, the figures did not change even working with an opening gap of -0.25%.

We have seen this kind of extreme price reaction only twice since the bear market low in the fall of 2002, both of which occurred this year (03/05/07 and 08/16/07). While there was some additional selling both times after the gap down open, the day of the gap marked a short- and intermediate-term low.

Looking at all 33 occurrences, buying the open and holding for the day was a mixed affair, leading to a positive return about half the time. On average, the winners out-gained the losers and the overall average return was positive, but it was a toss-up as to whether the outcome was positive or negative.

But buying those opens and holding for two days showed better results. 70% of the trades gave a positive return in that case, with an average return of +0.5%. That includes the day of the crash of '87...without that one day, the average shoots up to +1.6%.

This kind of behavior marked the lows in September 2001, July 2002 and October 2002, but it also was seen in a few of the days prior to those lows, and one would have suffered some troubling short-term pain before a recovery.

Even including the days of the '87 crash, and the bear-market occurrences from 2000 - 2002, the one-month forward return after these kinds of gaps averaged +4.3% with 82% of them being positive. The average drawdown was a sickening -7.4% compared to an average maximum gain of +7.7%. If we take the days surrounding the crash out of the equation, then 89% were positive, the average return was +5.5%, the average drawdown was -5.5% and the average max gain was +8.2%. Still some tough short-term pain, but overall still a good long trade.

Back to the short-term probabilities, I looked again for this same setup, but only when the market was in a long-term uptrend (defined as a rising 200-day moving average). Then we get 11 instances over the past 20 years.

The Thursday before the crash of '87 still qualifies, which was obviously a horrid buy signal. Excluding that instance, the average two-day return was an exceptional +4.1% with 9 of the remaining 10 examples leading to a positive return. The average drawdown of -1.1% was swamped by the average maximum gain of +5.5%.

Looking at the one-month returns, all 10 were big winners - the average return was +8.9%, with a drawdown that averaged only -1.6% compared to an average maximum gain of a whopping +10.3%. Buying panic in an up-trending market would have gotten you killed that one time in 1987, but the others were mostly fantastic winners.

Over the past couple of weeks, I've spent a good deal of time going over some longer-term concerns. We were seeing an extreme amount of optimism in everything from small options traders to newsletter writers to Rydex traders. Some of that attitude has been adjusted downward with last week's debacle, but not much, and I continue to harbor some serious concerns in that time frame given last week's performance and those measures of sentiment.

On a shorter-term basis, I'm more inclined to side with the "bounce" idea based on what we went over earlier in this comment. The evidence is clear that buying into extreme oversold short-term conditions - especially during the fourth quarter, and especially especially during a generally up-trending market - leads to positive near-term results on a very consistent basis.

The S&P 500 cash index should have some decent support around 1485 - 1490, which looks to be about where it's going to open this morning. I put some cash to work at Friday's close, and will look to add another piece sometime today. As I mentioned earlier, there was often some additional selling beyond the opening gap in many of these cases, so we could see some more pressure as the day wears on, but I do expect to see higher prices over the next couple of days. After that, I'm not so optimistic.

Could we crash here? Of course we could - nothing is impossible. I seriously doubt we will, but regardless it's important to always have risk control on any position. I would not suggest any short-term trader put capital to work on days like this without the ability to monitor the situation at all times, and getting out if the trade moves beyond your risk parameters.

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