Snapshot Notes - June 18, 2008


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WEDNESDAY, JUNE 18, 2008

Oversold Conditions Don't Matter As Much

06/18/08 3:10 PM EST

As of:

SPX 1386

HELP ARCHIVE

The indices have been struggling all day today, as we're buffeted by rising commodities prices on the one hand, and yet more trouble in financials on the other.

Many of those financials have actually been working steadily higher during the day, but it hasn't been enough to completely bail out some of the senior indices like the S&P 500 or DJIA. Both of those have fallen enough to challenge recent lows (last week's in the case of the S&P and the 12,000 level in the DJIA).

The selling pressure has been severe enough to pull a few of our most sensitive indicators into oversold territory, but oversold conditions haven't been all that reliable over the past month - a hallmark of weak markets.

This morning we discussed the Hindenburg Omen, as it had triggered each of the past two days. The last two times it did so were last July and October, both excellent warning signs of more trouble to come. Historically, such signals have been more successful than not at highlighting times of heightened market risk over the next few weeks to few months, though the Omen's mysterious reputation for preceding actual market crashes is more hype than help. Weakness, yes...crashes, no.

In addition, yesterday morning we went over several gauges that were suggesting that we were overbought, and the market took an immediate tumble. A market that falls immediately after becoming overbought, and which does not respond quickly or well when becoming oversold, is not a healthy one. Given the technical condition of most of the indices (declining 200-day moving averages, broken uptrend lines from the March low, a series of lower highs and lower lows), we have all the ingredients for a market where holding a large slug of equities takes a leap of faith.

This morning, we also discussed one potential bright spot, and that was the latest Investor's Intelligence sentiment survey. That poll showed a big jump in the number of folks looking for a decline, and it has reached extreme levels. Not quite what we saw in March, but it's getting close. Combined with the other surveys we follow, it shouldn't be long, or take too much more of a decline, to register some true historical extremes of pessimism.

Of course, those surveys just tell us what people are saying, not what they're doing. The indicators we follow which track that aren't as extreme, and it will take more time to suggest that we're seeing the kind of extremes we saw in January or March. And it's those kinds of extremes that I need to see in order to have some confidence in buying and holding stocks during a bear market.

On a short-term basis, the last two days have done a good job of wiping away the overbought conditions from a couple of days ago, and I suppose a weak argument could be made that we're approaching an "oversold on support" setup. But given the weak technical condition we're in, I'm not nearly as excited about that possibility as I was last year. It seems late to try to press any short-side bets here, but as for longs I just don't see the kind of pieces in place I need to want to take that kind of exposure.

Uh-oh...Another Omen Has Triggered

06/18/08 9:10 AM EST

As of:

SPX 1386

HELP ARCHIVE

Good Wednesday morning...We begin the day with a fairly large gap down open as we face a barrage of bad news. From FedEx giving a poor outlook, to Morgan Stanley reporting a 50% drop in earnings, to yet another bank trying desperately to raise capital and stem losses, to commodities (and inflation expectations) rising, to foreign markets taking a hit, the world seems about as much in peril as it seemed everything was wonderful yesterday morning. Of course, yesterday morning saw a big reversal, which is how these things often work - the pre-market futures are rarely a good indication for trading during normal hours.

One of the things that amuses me about the market, and its participants, is the tendency to see a certain idea be introduced, gain a little traction, and then become so much a focus that nothing else seems to matter. It's like my daughter, who I swear has obsessive/compulsive disorder - for the past week she's been glommed on to these little wrestler figures, and nothing else in the world matters except them...until the next little trinket catches her attention.

Right now the focus du jour for traders appears to be the Hindenburg Omen. This is a ridiculously data-mined (i.e. optimized to fit past data) signal that is supposed to be an early warning of a market crash. The good thing about it is that it has worked relatively well in real-time trading, despite the data-mining, but the bad thing about it is that it gives a lot of false warnings (in terms of the market not crashing).

The last time I wrote about this was last October, and it obviously did a good job at highlighting the risk that was to come. I bring this up now because we've now had two consecutive days with a Hindenburg Omen, same as last October. So I'm going to re-print what I wrote then, as it's just as applicable.

Please, please (please!) don't email me and tell me that such-and-such says we haven't generated a signal yet - there are several versions of this Omen, and almost everyone has different data vendors. I'm using the same data source I've used since 1962, so this signal is valid according to the back-testing I've done.

Here's the note from last October (I've corrected the spelling of Hindenburg):

"I'd like to touch on another potential negative, simply because it is getting quite a bit of attention. It is called the Hindenburg Omen, and it's something I've written about several times in the past. This market crash signal is generated when there is a big split in the market, with at least 2.2% of all stocks traded on the NYSE hitting a new 52-week high, and another 2.2% (or more) hitting a fresh 52-week low. There are some other parameters involved to validate the signal.

I have some issues with data like this because it crosses the border into data-mining. Give me enough computer power, and I'll find a combination of indicators that has predicted 100% of the market crashes...but t would be meaningless going forward.

The thing with the Hindenburg Omen is that it has been around, in real-time trading, for decades, and has continued to have a moderate-to-good success ratio at preceding market weakness. The last time we got two consecutive days with a Hindenburg Omen (we got three in a row this week, by the way) was July 23rd of this year, which was obviously an excellent sell signal.

Going back to 1965 and looking for any unique period when we had two straight days with a Hindenburg Omen, I can find 20 occurrences. Returns going forward were modestly weak in the short-term, up to 10 days later, but became successively weaker as we go further out, up to three months later.

Looking at those three-month returns, the S&P 500 was positive only 6 of the 20 times (30%), with an overall average return of -1.9%. The maximum gain during those months averaged +4.9% compared to an average drawdown of -8.7%. There were two big failures, in October 1995 and January 1998, but other than those two one would have been well-advised to exercise caution after these signals. The max loss / max gain ratio without those two instances was 3-to-1.

Again, I have some trouble staking an investment outlook on this signal because of its origination and the various rules surrounding it, but it has proved itself over time to be successful at highlighting periods of questionable market performance. It's another thing to add to the other potential negatives we've discussed."

With the last two days both triggering an Omen, we now have the same setup as we did last July and October. Again, I don't want to make it seem as though we all need to head for the nearest bomb shelter because of this overly data-mined signal, but the underlying theory of the Omen is a good one, and it's troubling that we're seeing such a split in the market.

This is especially the case because of what we went over yesterday. The broader indices are in terrible technical shape, and we'd seen several signs among the shorter-term indicators we went over that the past few days of rallying triggered readings that were so overbought as to probably lead to another downleg in stocks.

One potential positive is that we shouldn't have too far to go before we get a solid batch of "excessive pessimism" readings among a large number of our indicators. One hint at that is the latest Investor's Intelligence sentiment survey, which showed a huge drop in already-low expectations in its latest release.

The Bull Ratio (bulls / (bulls + bears)) in that poll is now less than 50%, meaning that there are more newsletters saying they're negative than positive. Going back to 1969 and checking for other times we'd seen that, the market has had only slightly better than random performance one and three months later.

However, the survey was extremely noisy during its first decade or so, making huge week-to-week swings, so if we test the data from 1982 forward when it began to settle down, then we get much better results (of course, a significant part of that is also due to the big bull market during the majority of that time).

Anyway, since 1982 when the Bull Ratio was under 50%, then one month later the S&P 500 was positive 67% of the time with an average of +1.5%, and three months later 75% of the time with an average of +4.5%. Since the mid-1990's, the signals have been nearly flawless.

So there is some hope for those with a more intermediate-term time frame that some shorter-term weakness here will generate enough pessimism to help form a bottom not too far from where we are now. But we're not at a point yet that I am interested in buying into falling prices, such as this morning's gap. Big gaps are usually emotional traps that have a strong tendency to reverse, but if we continue to make lower intraday lows after the first hour of trading, then I suspect we're going to be in for another rough day. Given what we went over yesterday and this morning, this is not the kind of environment where I want to be long.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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