Snapshot Notes - December 21, 2007

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FRIDAY, DECEMBER 21, 2007

Getting Overbought Heading Into the Holiday

12/21/07 2:55 PM EST

As of:

SPX 1483

Today we've been able to witness what has become an endangered species lately - a trend day to the upside, where we open at the low and (perhaps) close at the day's high.

There are no hard-and-fast rules for what constitutes a "trend day", but what I look for is buying pressure that usually takes us to new highs on the S&P 500 every time the NYSE TICK approaches the zero line. And when the TICK hits an overbought extreme above +1000, then the S&P backs off no more than 2 or 3 points.

We've pretty much satisfied those criteria today, and it's not just an academic exercise. It can be useful in the sense that if we identify these days by mid-morning or early afternoon, then we know that the majority of the time the day tends to close at or near the day's high - it's rare to see this kind of buying pressure, lasting this long into the day, completely reverse and lead to a nasty downside reversal before the close.

The pressure has been consistent today, there can be no doubt about that. The lowest TICK value so far today (according to my quote vendor, at least) was -415, meaning that at the very worst point today, 415 more stocks on the NYSE traded on a downtick (lower than its previous trade) than traded on an uptick. A normal day sees at least one TICK at -800 or below.

The last time we saw this kind of buying persistence was - no surprise - one year ago. December 27, 2006 was the last time we'd seen such a thing, and November 24, 2006 the time before that. When we get solid buying pressure near a holiday, then opposing traders tend to give up and let the bulls have their day in the sun. How sweet of them.

But if you take a look at 11/24/06 and 12/27/06, then you'll notice that both instances marked a short-term high. Immediately thereafter, selling pressure hit and erased much or all of the gains. Umm, maybe they're not so sweet. More like devious.

I'm concerned too that this is coming during an options expiration. I went over some stats this morning related to big gap up opens on expiration days, which told us that buying these opens and holding through Monday's close resulted in only 22% winning trades.

I could find only one instance since 1982 (when options trading really picked up steam) that we were as short-term overbought as we are now, on an option expiration that immediately preceded a pre-holiday session. That was December 21, 1990, when option expiration also preceded Christmas Eve.

While the market is usually positive the day before Christmas, expiration hangover won out that time, as the S&P dropped 0.6% the day before the holiday, then it just flopped around through the end of the year before shedding another 6% right away in January.

With our shortest-term guides now in or near overbought territory, and the somewhat ominous stats I've outlined today, I'll be pulling back further in managed accounts. We sold a little at the open and have let the rest ride, but I want to be lightly invested heading into next week.

I think we might see one more opportunity to take advantage of the "oversold in December" phenomenon you're probably sick of reading about by now, but I don't want to push too hard on the long side given the concerns I've outlined here. Maybe we'll make it far enough for the S&P 500 to butt up against 1490, but even so I'm officially going to move the site to short-term neutral at this point.

Another Gap, But Will This One Fade?

12/21/07 9:25 AM EST

As of:

SPX 1473

HELP ARCHIVE

Good Friday morning...We begin the day with a large gap up open in the major indices, as foreign markets were solidly higher, there has actually been a bit of good news flow, and traders are beginning to file out for a long holiday weekend.

I mentioned yesterday that if someone was determined to present a case that investor sentiment is too optimistic at the moment, then they could easily find some data to back that up. But that also applied to those trying to support the opposite argument, as there is some evidence that investors are currently too risk-averse.

One example I gave was mutual fund asset flows, and that was reinforced last night with the latest data from AMG Data^TM. That service monitors the flow into and out of mutual funds and ETFs, and posts reports weekly on its findings.

The current week's release was rather shocking in how extreme it has become. Over the past week, investors yanked more than $15 billion from equity mutual funds (not including ETFs), with about 60% of that coming from domestic-focused funds and the rest from those concentrating on foreign markets.

It must be noted that many funds make capital gains distributions during December, so it's not unusual to see increases in outflows during the month (I've circled big outflows during the past couple of Decembers).

But this year, the outflows are several times what we saw the past couple of years during December - investors made it clear that they wanted their distributions in cash, and not re-invested in additional fund shares. That's a pretty clear indication that investors are speaking with their wallet, and they want nothing to do with the recent volatility. Typically, that is a positive contrary indicator for the market.

It may seem odd, then, that we see a reading like yesterday in the Equity-only Put/Call Ratio. That measure showed that traders bought and sold only 42 put options for every 100 call options, the lowest such ratio in nearly two years. Generally, this is also a contrary indicator - when there are few puts traded relative to calls, it suggests a certain level of complacency.

But (and this is a big "but"), option expiration is today. One of the last times we saw such an exceedingly low put/call ratio was December 15, 2005, which was also the day before a December option expiration. Plus, we don't know what traders were doing with that volume - they could have been selling a bunch of calls, and not buying them, which would give us a totally different inference.

We can get a little better feel for that by also looking at the ISE Call/Put Ratio, which closed yesterday at 110. That means that traders bought only 110 calls for every 100 put options, a very neutral reading. If traders were tripping over themselves to buy call options betting on more of a rally, then the ISE ratio would have shot up to 200 or more.

I don't often read much into individual days' put/call readings, rather I prefer to look at them over a period of 5 - 20 days. And I read even less into them when we're in the few days surrounding an option expiration, like we are now. So while yesterday's reading looked like an ominous sign of investor greed, it's not quite that simple and I don't think nearly as ominous as it seems at first glance.

Since early this week, I've been harping on the concept of "oversold in December". We were seeing a multitude of signs that the selling pressure had gone too far, too fast given the time of year. That wasn't based on any sentiment or breadth measures that we follow, rather all the studies we went over were based purely on price action. No matter from which angle we viewed the data, it was clear that buying into selling pressure like we saw to begin the week, when holding through the first couple of sessions of the new year, was a consistently winning strategy.

I'm not a huge fan of trading based on seasonality alone, and I very much prefer to have some support from breadth- or sentiment-based extremes, and we weren't really getting many of those except from our most sensitive indicators. Because of that, and the inability of the indices to hold onto the slightest of gains, I have been interested in buying into dips, but not chasing prices higher. Trying to bet on upside momentum for the past couple of weeks has led to nothing but disappointment.

We're seeing some follow-through now from the recent strength, but it's coming in the form of a large gap up open. I've discussed at length why I detest these things (when occurring in the direction of my trade), and we saw a perfect example why yesterday. When we open for regular trading far from where we closed yesterday, it's an indication of emotional hype and very consistently leads to a counter-reaction.

Let's take large gaps up on option expiration days as another example. Anytime the S&P 500 exchange-traded fund , SPY, has gapped up 0.5% or more on one of these Fridays since 1993, buying at the open and holding until the close resulted in 44% winning trades. But holding until the next day's close resulted in only 22% winning trades (4 winners out of 18 attempts).

11 of the last 12, dating back to 1999, have been losers. There has only been once this occurred during a December expiration, which was in 1999, and that led to a 1% drop over the next couple of days (before a big rebound into the new year). Of course, our current setup runs right smack into the Christmas holiday, which has tended to show moderate positive returns in the days immediately surrounding the break. I'm not sure which takes precedence, as they have both been consistent.

Given the gap and the recent tendency to fade hard from them, I'm leery of this morning's open. I have absolutely no intention of trying to add to long positions into the gap, particularly as we're set to open right at resistance around 1470 in the S&P 500. A big gap up on expiration Friday that opens right at resistance doesn't seem like the best opportunity to me, and in fact I'll likely be selling some into the open.

We could be OK as long as we don't fade immediately at the open, in which case I would use the low set during the first hour of trading as a sell stop exit on some existing long positions. I still think we head higher into the new year, but obviously I don't know that for sure, and I want to trade around what I have. I'm reducing the signal strength from 50% Long to 25%, assuming the cash S&P would be around 1473 at the moment.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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