Snapshot Notes - May 27, 2008


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TUESDAY, MAY 27, 2008

Bullish Factors Getting Played Out

05/27/08 3:55 PM EST

As of:

SPX 1386

HELP ARCHIVE

Going into last week, we had gone over a number of potential negatives that the market was facing, too many to list here. When the indices broke out to new multi-month highs on Monday morning, those negatives looked horribly wrong, but the afternoon reversal touched off several more days of selling pressure.

As a result, we started to see some more constructive patterns and indicator readings later in the week, mostly on Wednesday. As we discussed on Thursday morning, the chances for a snapback, particularly in the tech-heavy Nasdaq 100, seemed inviting. And while the other indices sold off relatively hard on Friday, the NDX did manage to hold tough and led us higher today.

Now it becomes more difficult to determine where the odds lie. Our most sensitive indicators are no longer oversold, and in fact a few have already made the transition to flirting with overbought territory. The Down Pressure indicator we mentioned last week will relieve its oversold condition today, and also satisfy a bounce in the three-day time frame within which that gauge is most effective. We do still have some positive seasonality afoot, as the end-of-May/beginning-of-June area has most often seen stocks do well.

But many of the negatives we discussed prior to last week covered a one- to three-month time frame, and last week's trading was quite disturbing - a market that can't rally off of short-term oversold conditions and technical support levels is not healthy, and that often signals a change in trend.

So we're facing a market that as far as I'm concerned is still within the throes of a bear market, the panic studies we went over in March have mostly played out, we saw multiple signs of too much optimism coming into last week, and then last week stocks put in a pathetic performance. That tells me that I should be looking harder for the next shorting opportunity rather than pushing aggressively on long positions, particularly in the "broken" indices like the S&P 500 and DJIA.

From what I'm seeing right now, I can't find a solid edge either way for the short-term. The bullish bias from last week worked out OK in the Nasdaq 100, but didn't have much of an impact in the broader market. About the best edge I can find on the long side right now is seasonality, which I always find to be a crutch that's mounted on soft footings. From the short side, the setups are becoming more attractive, but I'm not quite ready to bet against this so-far meager bounce attempt. If the S&P 500 climbed closer to 1420, then I think we'd be better able to make a case for the short side, so we'll see what we get as the week progresses and traders react to the upcoming economic reports, several of which have the potential to be market-moving.

Have a good evening and we'll see you tomorrow!

Further Pressure Should Lead to a Bounce

05/27/08 9:25 AM EST

As of:

SPX 1391

HELP ARCHIVE

Good Tuesday morning...We begin the day with a modest bounce in the pre-market futures. Overseas markets were mixed while U.S. traders were away from their desks. We have some economic data that may have a temporary impact today in the form of new home sales, but otherwise traders will be looking for guidance with a flurry of reports later in the week.

Last Thursday, I highlighted a few studies that suggested stocks were oversold, at least in the technology-laden Nasdaq 100. Based on the configuration of stocks above their 10- and 50-day moving averages, an extreme in our Down Pressure gauge and the price pattern over the prior few days, it looked like a pretty good bet that the NDX would see a short-term snapback.

We didn't see much of one to end the week, though the NDX did certainly show some good relative strength compared to the other major indices. I'm not a big fan of rationalizing a study by saying "well, at least we lost less than we could have" - relative performance is a game for long-only mutual funds and stat-arb hedge funds. Here in the real world, I want to show positive absolute performance. Technically, I guess, the NDX is showing a gain over the past two days, albeit a measly 2 points.

I went back to that Down Pressure study we looked at and tried to find any time when it recorded a reading as extreme as it did on Wednesday, but then petered out and showed a loss or a gain of less than +0.15% over the next two days.

Surprisingly, the results were still quite positive in the short-term. The NDX was up the next day 80% of the time (12 out of 15) with an average return of +1.4% and three days later it was up 73% of the time with an average of +3.4%. So just because the index hasn't responded immediately may not be the worst sign, at least based on that measure.

One troubling indication, at least for today, is that the market did not respond to the usual pre-holiday positive seasonality. As we went over on Friday, when stocks have not responded well on the day before a holiday, they have tended to fare just as bad on the day after.

Something else I'm not thrilled with is that options traders are not showing much concern. Too much enthusiasm among these guys and gals was one of the negatives I'd been harping on heading into last week. Last Monday morning, I showed a chart of how little options traders were demanding put option protection, which was on a par with other periods where stocks were about to run into trouble.

That chart showed that small traders had put about 18% of their total volume into buying protective put options, which was a small amount. Because these traders tend to be reactionary, we could have reasonably expected them to shift gears and demand more protection now that the S&P dropped 50 points in one week.

No such luck...despite the loss in the major indices, these traders actually reduced their put buying last week, spending only 17% of their volume on puts. They reduced their call buying, too, but increased selling-to-open both put and call contracts, likely looking to take advantage of the increase in premium due to the bump up in implied volatility.

I don't like to see that, so I checked for any time since 2000 (the furthest back I have this data) to look for any time that the S&P sold off 3% or more during the week, but small trader put buying actually decreased, and was less than 20% of total volume. There were 10 occurrences.

The results going forward weren't as bad as I feared. The following week, the S&P was up only 4 times out of 10, but showed a positive average return of +0.7%. Only one of the six losing weeks showed a return worse than -1%. Two weeks later, the S&P was up 7 of the 10 times and sported an average return of +1.2%. After that, up to three months later, the returns kind of see-sawed and didn't show much of a pattern.

Last week was a wicked-looking one on the charts, with major indices like the S&P carving out "outside down" weeks. That means the S&P had a higher high than the week before, but also a lower low and lower close. I went back since 1950 and looked for any other time the S&P did even worse - any time it hit at least a three-month high, then reversed down to close below the low of the prior three weeks.

There were 6 such instances in the past 58 years, and the following week the S&P rebounded 4 times with an average of +0.8%. Two weeks later, it was up 5 of the 6 with the same average return, and a month later it was positive all six times with an average of +3.7%.

During the month, the average maximum risk of -1.7% was quite small compared to the average maximum reward of +4.7%. Three months later, the S&P was still positive all six times, sported an average return of +7.6%, and showed a max risk (-2.1%) that was swamped by the max reward (+10.1%). Nothing bearish about that pattern at all. For those curious, the weeks were 9/23/63, 1/6/86, 6/26/89, 10/9/89, 4/16/90 and 11/11/91.

Many of the negatives we'd been discussing coming into this week were intermediate-term in nature, and last week's trading helps to confirm that those negatives are taking hold. A market that can't rally off of short-term oversold conditions and technical support levels is usually not healthy. It is often a sign of a change in the larger trend, which we last saw in January.

I've contended since the first couple weeks of the new year that we were in the midst of a bear market, and continue to be. Many of the studies we went over in March and April suggested a rally of 5% - 10% over one to three months, and that's what we've seen - anything beyond that, most of the studies couldn't account for. Now that we've met many of those targets, remain within a bear market environment, have seen multiple signs of too much optimism coming into last week, and have the poor market performance that stocks put in last week, the picture doesn't look too bright for the intermediate-term.

There are some positives we can point to in the short-term, and if we continue to sell off early this week, then I think the chances are quite good that we'll get a decent end-of-month/beginning-of-month rally into early June. If that occurs, though, then I suspect that it's going to set us up for a better opportunity to short than the one we got last week.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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