FRIDAY, MAY 16, 2008
A Tough Week for Non-Believers
05/16/08 4:30 PM EST
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As of: SPX 1375 |
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Coming into this week, we had spent a couple of weeks going not much of anywhere in the broader market. Some of the negatives we'd discussed a couple of weeks ago were alleviated with the minor sell-off last week, then this week we got a rather steady move higher.
Towards mid-week, we went over a few studies related to option expiration that showed how rallies into mid-week tend to peter out over the next several days. That didn't seem to matter this time around, however, as there was an omnipresent bid underneath the market all week.
That has triggered a few more extremes as prices have pushed higher. We're seeing the Dumb Money Confidence surge to levels that have marked danger zones for prices in the past, and there also has been a spurt of excessive speculation in Nasdaq issues, seen from the flow of Rydex assets and Nasdaq volume relative to NYSE volume. This is in the context of a market still mired in a long-term downtrend and facing a seasonality headwind.
But we're just not seeing those negatives reflected in prices, at least in most sectors. One exception is Financials, which have been getting hit harder than a Twinkie at Overeaters Anonymous.
Going back to 1993, I could find 211 days when the BKX Banking Index suffered the indignity of a loss as great as today's (-2.25%). Of those 211 instances, the S&P 500 showed a negative return on the day 204 times. Which means that what we saw today is something we've seen only 3% of the time in the past.
Of those 7 instances, the S&P 500 fell over the next week 5 times, and sported an average return of -1.6%. That has been a fairly consistent pattern with the banking sector - it tends to act as the tail that wags the dog, at least when they show a pattern of great under- or over-performance to the broader market.
Their relative under-performance can be clearly seen over the past two weeks. While the S&P has managed to straggle higher during that time, the BKX has sold off more than 6%. The table below shows other times that has occurred during the past 15 years, along with the go-forward returns in the S&P over the next one and two weeks.
The table tells us that the S&P managed a gain over the following two weeks only one time, and that was a meager +0.5% gain.
This kind of odd behavior makes making solid judgments all the more difficult. I went over my reasoning this morning for why I'm leaning against a further sustained rally - I still think we have a better chance of lower prices than higher ones in the coming days - but I don't plan on sticking around too long if this unusual activity keeps pushing us to higher highs.
Have a safe and relaxing weekend, and we'll see you next week!
Odd Behavior Continues
05/16/08 1:30 PM EST
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As of: SPX 1375 |
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Another day, another version of "the amazingly resilient bid".
After the major indices took it on the chin during the first hour and a half of trading, we bottomed out (again) around 11:00 and have continued higher in a tight trend-day type of pattern.
I mentioned earlier this morning that we've been seeing quite a few correlations breaking down, and here's another one. I checked all days since 1993 for times when the BKX Banking Index was down at least 2% on the day, and the yield on 10-year Treasury Notes was also down 1% or more, as both are today.
There were 93 days that qualified, and here's the kicker...out of those 93 days, the S&P 500 showed a negative return 91 times, averaging a hefty loss of -2.2%.
There were only three days out of that entire sample when the S&P didn't lose more than -0.5% (8/25/99, 6/26/02 and 4/4/08). Not that we can read much into just three instances, but over the following week, the S&P dropped by more than 2% each of those three times, with an average of -2.7%.
This kind of behavior is what's making this juncture difficult for me. I went over my reasoning this morning for why I'm leaning against a further sustained rally, though this odd behavior makes it difficult to have a lot of conviction because it makes it seem as though anything can happen and all the probabilities in the world don't matter. I still think we have a better chance of lower prices than higher ones in the coming days, but again I don't plan on sticking around too long if this unusual activity keeps pushing us to higher highs.
Seeing if the Bulls Can Hold
05/16/08 9:20 AM EST
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As of: SPX 1375 |
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Good Friday morning...We begin the day with a another slight bump up in the pre-market futures on this option expiration day. Despite its wild-and-wooly reputation, option expiration tends to be a fairly tame day as far as directional moves go. High volume and relatively small intraday ranges are hallmarks of these days, which is why many traders decide to play golf instead of try to trade them (unfortunately, I don't play golf).
I want to touch on a couple of biases related to recent market performance and option expiration, but I'm not going to push it too hard because the other ones we looked at this week haven't helped us.
Using the S&P 500 tracking fund (SPY) since 1993, whenever it has made a three-month high the day before option expiration, the S&P showed a return through Monday's close of -0.2% on average, with 40% of instances being positive (13 out of 32). If the three-month high occurred on a 1% or larger daily gain, like it did yesterday, then the S&P was 0 for 4 through Monday with an average return of -1.7%.
Forgetting yesterday's rally or the break to a three-month high, if the S&P gapped up any time by 0.25% or more on an expiration Friday, then buying at the open and holding through Monday resulted in 39% winning trades (18 out of 46) with an average of -0.3%, and an average risk (-1.4%) that was twice as great as the average reward (+0.7%). All 9 occurrences during the last bear market showed a negative return through Monday, averaging -1.7%.
One of the reasons bulls have had more confidence is that more-speculative issues like those in the Nasdaq 100 (NDX) and Russell 2000 (RUT) have been leading lately. The theory is that if investors are showing a healthy risk appetite by driving those shares higher, then it should bode well for the broader market.
I took a look at how the S&P 500 (SPX) has done when the Russell 2000 is leading. What we're looking at here is a five-day average of the relative strength of RUT compared to SPX. We'll buy when then the average starts to slope up and sell when it starts to slope down.
Over the past 20 years, such a strategy would have netted us 366 points in the S&P. That's out of a total of 1165 from buy-and-hold. If we flip the strategy on its head and buy when the RUT is lagging, then we would have netted 757 points.
So we would have actually done twice as better in the broader market by buying when small-cap stocks were lagging, as opposed to leading. We also would have had a greater percentage of winning trades, with bigger winners and smaller losers. So much for the "buy when small caps are leading" argument.
Anyway, yesterday after the close I noted that my reasoning for betting against a sustained rally has been that the indices had already met most of the projections from the studies we went over in March, we are still mired in a long-term downtrend (a downward-sloping 200-day moving average), we've been witnessing an historical drop-off in exchange-wide volume, implied volatility has fallen faster than justified by the move in the underlying indices, seasonality is the worst since the summer of 2006, we're seeing a smattering of "excessive optimism" readings (including the newest entries...Dumb Money Confidence and the Rydex NDX long/short ratio), and the major indices were all below what should prove to be resistance.
Three of the four major indices have now broken out over that resistance, which takes away one of the negatives - particularly if it can hold over the next day or so, reducing the probability that we're witnessing a "false" breakout.
Another unusual data point is that Treasury Note yields broke down hard yesterday, with the 10-year yield shedding nearly 2.5%. Since the October high, it has dropped that much 17 times...and 16 times, the S&P 500 also fell on the day (the one exception was January 30th).
So yesterday's 1%+ rally in stocks was something we haven't really seen much of since the latest trouble began. Depending on which side of the fence you fall on, you could either consider that a very positive change as stocks begin to trade on their own merits instead of global structural concerns, or it's a negative because the move in stocks was "fake".
I find that latter argument hard to swallow, even though I'm positioned net short. As I've been noting over the past week or so, many of the inter-market correlations that have consistently held since October are breaking down, and even though I've bet against the rally for now, I think overall that's a positive for stocks going forward.
Bottom line, I have a very difficult time chasing prices higher here, as the probability of these gains being given back seems high. I'm net short (and squirming because of it), but I will not forsake risk control just because I think I will be right eventually. If we continue to hold above the previous resistance levels on the major indices (1420 for the S&P, 2000 for the NDX and 740 for the RUT), then as a matter of discipline I'll have to reduce exposure or excuse myself from the short side, no matter how wrong that may feel at the time, and look to re-enter if/when prices show some better signs of weakness taking hold.
All the best,
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
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