Snapshot Notes - June 2, 2008

In a note this morning, I mentioned that equities were showings signs suggesting that we should see more weakness ahead.

While not quite meeting the classic parameters of a trend day (which are relatively rare to see on the downside), we were seeing the indices make lower intraday lows after the initial gap down opening, selling pressure appeared when the NYSE TICK popped above the zero line, there was very weak breadth, almost all sectors participated in the decline, and the BKX Banking Index hit new multi-month lows.

That's a tough combination for a market to stage an upside reversal, and when S&P came out and downgraded the outlook for banks and brokers, that sealed the deal for the afternoon.

That finally changed the pattern of good first days of the month, and marked the worst month-open since January, provided we don't get a substantial late-day recovery. The table below shows how the S&P 500 has fared going forward when opening a new month with a loss of 1% or more:

S&P 500 Performance When Opening a Month With a 1% or Greater Loss
	1 Day Later	5 Days Later	10 Days Later	Rest of Month
Avg Return	+0.1%	-0.1%	0.0%	+1.2%
% Positive	57%	41%	51%	64%
When the 200-day Moving Average is Sloping Down...
Avg Return	-0.2%	-0.1%	-0.2%	+1.5%
% Positive	48%	40%	44%	73%

The returns going forward weren't horrible, but were worse than random. When the market was in a downtrend at the time, the next week showed a rebound only 40% of the time. However, by the end of the month the S&P showed a positive edge nearly three times out of four.

Besides opening with a loss of more than 1%, last November we also saw a similar pattern with the VIX implied volatility indicator. That was the last time we saw that indicator close at at least a one-week low (like it did on Friday), then spike to close at at least a one-month high the next day (like it's poised to do today).

Going back to 1990, I could find 17 other such instances. Over the next three days, the S&P actually showed a positive return 71% of the time with an average of +0.3%. However, those bounces tended to be short-lived. By two weeks later, it was up only 40% of the time and sported an average return of -0.7%. These volatility spikes can oftentimes precede trend changes, which is why we see poorer longer-term returns. So after short-term knee-jerk snapbacks, the rallies have typically failed.

Some of our most sensitive indicators cycled into oversold territory with the decline this afternoon, but we're not seeing anything too outstanding there. The indices are holding above last week's lows, which is going to be a line in the sand for many short-term traders (myself included). With a smattering of already-oversold indications, some possible beginning-of-month positive seasonality and the tendency to see snapbacks after big down days like this, I suspect we're going to see some kind of rebound over the next one or two days. But I don't have high hopes for it, and I believe that last week's lows aren't going to hold.

Good Monday morning...We begin the day with weakness across the board as overseas news put a bit of a scare into domestic traders, and the morning economic releases weren't enough to turn the tide.

Data released over the weekend was mostly inconclusive. We've been discussing small-trader option sentiment since late April, when it began to show some troubling signs. By then, these traders (trading 10 contracts or less) were spending less than 17% of their total volume on opening put purchases, a way to protect their portfolios from a market decline.

For the past month, they have been spending right around that amount on put options. Despite market losses the week before last, they actually decreased their put buying from the week before, which seemed a bit troubling. Last week, we saw several days with quite low put/call ratio readings, but it didn't really translate into the small-trader data we see weekly. The latest data didn't show much of a change in the behavior of these traders - they're still not buying many puts, but they haven't increased their speculative call buying, either.

One piece of data that did stick out was the Public Short Ratio. This indicator looks at all short sales made on the NYSE, and computes what percentage of those short sales were initiated by the public. The "public" in this case includes small traders, but is not limited to them - it also includes large hedge funds and anyone else that isn't an NYSE member.

The data is released with a two-week delay, so it has really no use for short-term trading. But it has helped in the past with determining where in the sentiment cycle we are, and the latest data was surprising. Fully 70% of the short sales made during the week of May 16th were made by the public. That's the 2nd-highest amount in history. The only week that eclipsed that was November 16, 2007. The week of August 17th, 2007 came up third.

Those were both OK times to be looking for a rally. The November instance led to a rally through early December, but due to the delay in the data, we didn't know about the extreme in this indicator until the rally had almost already run its course. That's the difficulty in using some of this longer-term data for shorter-term trading.

There has been a secular decline in this indicator due to the decreasing role of specialists on the NYSE, so perhaps we'll see it go on to make lower lows, but I thought it was at least worth a mention. If we continue to see the public sell short stock so heavily, it may help to contain a correction.

We ended last week with a multi-day rally that culminated in a low-volume, narrow-range day. We discussed on Friday the fact that all of those conditions (multi-day rallies, low volume and narrow ranges) tend to precede sub-par returns, and it was basically unprecedented to see all of them come together all in one day during a down-trending market (i.e. a downward-sloping 200-day moving average).

That didn't seem like the best time for long-side traders to be pushing their bets, and we're seeing some after-effects of that to begin the new week. The first day of the month has had a positive bias historically, especially this year, but last week we went over that tendency when we had conditions similar to now (after the market had already rallied for several days), and that positive bias tended to go by the wayside.

I'm not seeing much here that would lead me to conclude that the negatives to end last week have already worked themselves out, so I continue to feel that we'll see more weakness ahead rather than a sustained rebound, especially given the activity so far this morning. We've seen the indices go on to make lower intraday lows after the initial gap down opening, selling pressure has come in when the NYSE TICK pops above the zero line, we're seeing very weak breadth, almost all sectors are participating in the decline, and the BKX Banking Index is hitting new multi-month lows. That should lead to further pressure in the broader equity indices.

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