Snapshot Notes - July 10, 2008

Good Thursday morning...We begin the day with flat pre-market futures that belie their early-morning volatility. The S&P futures were up more than 10 points earlier, then dropped about 15 points over the past hour. Commodities are mostly flat, foreign markets are weak but off their lows, the weekly jobless claims numbers were mixed, and retail sales were OK especially for lower-tier firms. Focus today will be on GE's earnings and any news surrounding Fannie Mae and Freddie Mac (and financials in general).

Yesterday's ugly session was enough to push our Smart Money / Dumb Money Confidence to a new level of extreme, with the Smart Money finally moving above 60% for the first time since March. Essentially, what we're seeing is that the Smart Money is 67% confident in an intermediate-term rally, while the Dumb Money is only 17% confident in the same.

That makes the spread between the two +50%, one of the highest readings we've seen over the past decade. The table below shows the performance in the S&P 500 since 1995 when the spread between the two have been this wide (there were a total of 25 days):

S&P 500 Performance When Smart/Dumb Spread Reaches +50% (since 1995)
	5 Days	10 Days	1 Month	3 Months
	Later	Later	Later	Later
Avg Return	+2.8%	+3.4%	+5.0%	+11.6%
% Positive	72%	80%	96%	96%
Avg Max Gain	+5.0%	+6.1%	+8.4%	+16.1%
Max Gain	+14.1%	+14.2%	+19.3%	+33.2%
Avg Max Loss	-2.7%	-3.3%	-4.1%	-5.6%
Max Loss	-9.8%	-11.5%	-11.5%	-11.5%

Prior to 1995, we had fewer inputs to those models, so the data is very jumpy. But we do have readings back to 1986, so the following table shows the same results as the one above, but uses all the data:

S&P 500 Performance When Smart/Dumb Spread Reaches +50% (since 1986)
	5 Days	10 Days	1 Month	3 Months
	Later	Later	Later	Later
Avg Return	+1.5%	+2.0%	+2.7%	+7.1%
% Positive	71%	76%	76%	95%
Avg Max Gain	+2.8%	+3.6%	+5.0%	+9.9%
Max Gain	+14.1%	+14.2%	+19.3%	+33.2%
Avg Max Loss	-1.6%	-1.9%	-2.6%	-3.4%
Max Loss	-9.8%	-11.5%	-11.5%	-11.5%

If it weren't for a three-day decline to end August 1998, the results in the tables above would be considerably more positive, with very few instances of drawdowns worse than -3%.

The poor market and inability to hold a rally is surely taking a heavy hand to the backside of investor optimism. The latest sentiment survey from AAII showed bulls taking another spanking, with bullish opinion among its members of individual investors falling to 22%, among the lowest 5% of all readings since 1987. Like the Investor's Intelligence survey of newsletters that was released yesterday, and which showed the lowest sense of optimism since 1994, we're clearly dealing with a depressed investor class.

It isn't just investors, either. The general population has all but given up on the economy, despite the theory that we haven't officially entered a recession (yet):

I'm not sure what those surveys would look like if we actually do enter a protracted contraction, but public opinion right now is as low as it has ever been in the past 30 years.

We're doubtless seeing a lot of indications of apathy and pessimism at the moment, but what we have not seen is panic. Maybe that's due to "everyone" looking for the same kinds of signs of capitulation. I had a subscriber email me an anecdote yesterday about a meal he had on Tuesday. His waiter told him not to trust the rally because the VIX hasn't hit 30 yet. That wasn't the waiter's brilliant insight, though...he had heard it from the Albanian dish-hand. Ugh.

I'm not much for using anecdotal evidence in my trading, but it's pretty exhausting seeing the constant media blurbs and blog posts about the lack of fear evident in the VIX. I suppose it's possible that too many folks are looking for capitulation, but that was also true in March and we got it then. It's hard to outguess the guessers.

I prefer to stick with hard data that we can quantify. On June 30th, I showed an indicator that we dubbed the Panic Button. It is made up of four indicators that jump only when uncertainty is at its highest levels, mostly dealing with the credit markets.

This indicator incorporates the TED Spread, Junk Bond Yield Spreads, a ratio of Volatility to 3-Month Treasury Bill Yields and High-Yield CDS Spreads. All of these spike higher when uncertainty about the economy and stock prices are high, and reach extreme high levels only during times of outright panic.

The indicator makes it clear that we have not seen anywhere near the panic we have near other lows since last August. In fact, there's barely even been an uptick since the May high. Only one of the Panic Button components is even high relative to past readings, which is the spread on Credit Default Swaps. Some of those have exploded lately as fears of corporate bankruptcies rise.

We've been discussing the need to see panic, or capitulation, over the past couple of weeks. We've been oversold for some time, but have not seen the telltale signs we had at prior lows. Using March 2003 as an example, we do not *need* to see panic in order to form a lasting bottom - but it helps greatly when trying to determine what our risk/reward is on a trade. Without it, we're just kind of guessing that we're seeing some kind of positive divergence in terms of other market lows, and I don't like to guess.

So with an oversold market - but no panic - we could keep trying to bottom-pick the low, or wait for some confirmation of price recovery. The former is a dangerous strategy because it opens us up to bleeding to death by a thousand paper cuts, continually taking small stop losses as the market drifts lower. At some point, we would be correct and it may be enough to make up for all the small losses, but it's a hard strategy to stick with.

The latter strategy, waiting for price confirmation of an uptrend, isn't always that much better. As we saw on Tuesday, buying into overbought markets during a downtrend and under resistance can lead to a real good spanking and an even larger stop loss if we hit new lows.

So pick your poison, right? My stance is that barring the kinds of quantifiable panic extremes that we've seen at past lows, I'm not willing to establish or add to long exposure into falling prices. I would, however, take a strong look at doing so if we manage to reverse yesterday's losses and hold above 1280ish on the S&P 500. That would be trying to buy into a price rise, and possibly overbought short-term conditions, which I'm usually loathe to do. It certainly carries its own set of risks, but at this point, given the readings we're seeing, I think another upside reversal has a better chance to stick and the risk/reward would be positive. That's what I'll be watching for over the next couple of days.

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