Snapshot Notes - July 14, 2008


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MONDAY, JULY 14, 2008

Trend Day In Reverse

07/14/08 3:25 PM EST

As of:

SPX 1386

HELP ARCHIVE

This morning, we discussed the idea that while we continue to have a few holdouts among our sentiment indicators, for the most part we're staring at a setup for another counter-trend bear-market rally.

It's true that the same thing could have been said a couple of weeks ago, but three pieces fell into place on Friday: 1) an explosion in new 52-week lows that equals the wholesale selling panics we've seen at other lows over the past six months, 2) the failure of IndyMac, which we looked at in terms of other big bank failures in a Data Brief late on Friday, and 3) some resolution in the Fannie/Freddie saga.

Coming into this morning, my though was that given those ingredients, we had a pretty good shot at seeing a trend day today. Indeed we have, but it's in the complete opposite direction as I thought was most likely. Once again, the first hour of trading was a great tell - if we were going to fail, it was going to be right away. If we had gone on to hit higher intraday highs after the first hour of trading, then the probability of seeing a sustained upside push would have been exponentially higher than the probability of us seeing a late upside reversal now.

This is truly a slap in the face on top of the pounding we got last month. I checked the history of the S&P 500 to see if there's been another time where it lost at least 8% one month, then began the next month with at least a 4% loss during the first two weeks, which we're currently on pace to endure.

There were five other comparably sickening slides going back to 1950, and generally the short-term was not pretty. We saw additional losses over the next week four of the five times, averaging a gut-wrenching -5.4%. The sole winner was a measly +0.9%.

Now for the bright side - that additional week of selling was most often the end of a capitulatory purge. Buying a week later (i.e. three weeks into the month, or a week from now) and hold for a week would have resulted in four winners with an average of +3.8%. Holding for a month would have given us all five winning trades, and an average of a whopping +9.2%. For those curious, this was seen in June 1962, May 1970, September 1974, March 2001 and July 2002.

I mentioned this morning that I was interested in establishing some intermediate-term longs, and I've started to do so. For short-term trades, though, buying into a large gap-up opening during a downtrend on a Monday is not always the best idea, and unfortunately we're getting a replay of that today. With a pretty full plate of widely-watched economic releases, a plethora of financial and tech firms reporting earnings, and continued headline risk (e.g. additional bank failures or rumors of such), this is going to be an exceptionally tricky week for short-term trading, especially if holding overnight.

I do believe that even if we hit a rough patch this week, it will prove to be the final puke sessions before a sustained rebound that should take us higher than the lows set today and Friday, given what we went over earlier today and last week. I'm still not doing much of anything trading-wise and don't see that changing at the moment, but from a longer-term perspective (one to three months) this market is finally looking like it has a decent risk/reward profile on the long side.

The Importance of New Lows and Failures

07/14/08 9:00 AM EST

As of:

SPX 1386

HELP ARCHIVE

Good Monday morning...We begin the day with a big gap up opening in the pre-market futures as the market follows though on the typical pattern that we discussed on Friday.

Commodities are backing off a bit from their recent run, foreign markets were strong with 1% gains common, the economic calendar is stocked with important releases today and tomorrow (PPI and retail sales tomorrow, CPI and Industrial Production on Wednesday, Jobless Claims and Philadelphia Fed on Thursday), and we're entering the thick of earnings season with a whole host of financials and techs reporting this week. I suspect we'll have plenty of opportunities to discuss gap openings as volatility should continue to be elevated, especially overnight.

When we see a decline like we have over the past month, on top of what we endured over the past six months, it's always tempting to find an opportune time to buy into a market that now seems to have more value than it did before. That can be very fruitful during a bull market, but during a bear market not so much.

We've spent a good deal of time over the past couple of weeks discussing why it probably wasn't a good time to do anything other than small, short-term trades despite the relatively dour sentiment condition we were witnessing. There have been bountiful signs of an oversold market (especially in terms of market breadth), and an increasing level investor pessimism, but very few signals hinting at panic or capitulation. The latter concept has become something of a cliché, but during bear markets it is very rare to see any kind of meaningful bounce not accompanied by clear signs of panic.

And that is something we had not seen. Sentiment was very pessimistic, yes...capitulatory, no.

That changed on Friday, as we finally saw wholesale selling pressure. New 52-week lows on the NYSE exploded to nearly 900 securities (using data from the Wall Street Journal), which is just under 30% of all issues traded on that exchange. Historically, readings above 25% have led to abnormally positive returns in stocks going forward, and has been an excellent signal over the past six months. We last discussed this aspect in November and August, and we also saw it at the January and March lows. An explosion in new lows is an important signal of an imminent low.

Most intriguing to me, however, is the simple fact that IndyMac failed, and the government revealed plans to prop up Fannie and Freddie. We went over this on Friday, with my best guess being that we'd see a bad day on Friday, then a weekend resolution of the Fannie/Freddie mess and a big gap open today. That's how these things tend to work, and we're seeing it play out yet again.

On Friday night, I posted a Data Brief that showed the S&P 500's reaction to past big bank failures. The charts spoke for themselves, and the numbers were impressive - over the next six months, the average drawdown in the S&P was a ridiculously small -2% while the average maximum gain was north of +20%.

We don't have all the pieces in place for a sustained low here, of course. Options traders in general, and small options traders in particular, never reached the kind of extreme that I prefer to see. Some of that could be due to inverse ETF funds and other alternatives to options, but that doesn't explain why we saw a spike in option activity in January or March. The lack of urgency in put option buying is also one reason why we haven't seen a big jump in implied volatility, a sign that occurred at other lows.

We also haven't seen corporate insiders buying aggressively, though one reason for that is the imminent release of quarterly earnings, and some firms have gone into a quiet period where insider transactions slow down. And Rydex traders have become pretty pessimistic, but we have not seen a big push into the leveraged inverse equity funds that have marked other lows.

I'm kind of nit-picking at this point, however. Looking over our indicators, there is no shortage of extremes we could point to that suggest we've hit an exhaustive point. It's not classic like January or March, but Friday's surge in new lows, the failure of IndyMac and the weekend Fannie/Freddie discussions certainly add a lot of weight to the argument that Friday's lows should hold. We'll almost certainly get a test of the potential low at some point, but for now I'm going with the idea that we've hit an inflection point and should head higher, with a risk/reward clearly skewed in favor of the long side. I'll be looking to add some intermediate-term long positions, with the understanding that volatility should be high in the short-term and we probably have some give-and-take ahead of us.

The tough part from a short-term perspective is this big gap open we're facing. We had a pretty good idea that this is what we'd face this morning, but the risk if I was wrong was too great for me to add any long exposure on Friday. And buying into a big gap up opening during a bear market - on a Monday - is not my idea of fun.

I think we have a decent chance of this turning into a trend day (where we open near the day's low and close near the high), so I'll be watching for the market to set a higher intraday high after the first hour or so of trading. If that happens, and we have extremely positive breadth readings and high TICK values as the morning wears on, I suspect we'll end the day at the highs and see yet more upside in the coming day(s). If we're going to fail, it should happen within the first hour of trading today.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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