A Further Push Probably Won't Be Sustained

08/28/08 9:20 AM EST

Good Thursday morning...We begin the day with a moderate gap up opening as the pre-market futures have made a large early morning swing after the release of the GDP report.

This is something we touched on earlier in the week - the bevy of economic releases this week, combined with the exceptionally low volume, will likely give us big swings in the pre-market, and we've seen that in spades this week (tomorrow shouldn't be any different).  Stocks have been able to hold up in the face of higher Oil very recently, and the commodity is up once again this morning.  Foreign markets are mostly showing largish gains (1.5%+) across the board after rebounding in the past 45 minutes.

For most of the past few weeks as the market has chopped around, we've seen the number of indicators at extremes slowly dwindle until we had a small handful on both the bullish and bearish sides of the ledger.

That kind of activity makes it tough to have any particular bias in any time frame, especially as the goodwill from the mid-July panic low subsides.  The indices' technical trends are mostly ambiguous, and we haven't looked at too many historical studies lately that gave us standout results either way other than a short-term one here and there.

Monday's big down day and the recent break of the July/August uptrend lines in the S&P 500 and DJIA seems to have raised the concern level among one group of traders, at least.  We're not seeing much worry among options traders - quite the opposite in fact - but traders of the Rydex mutual funds have become increasingly defensive over the past several sessions.

Both the leveraged and un-leveraged long-side index funds (which profit when the market rises) have had mediocre inflows since the July low, and the funds have been flowing back out during the past week.  More remarkably, the inverse funds (which profit when the market falls) have seen a relatively large inflow as traders speculate or hedge on a re-test of the lows.

That has pushed the ratio between assets in the bullish and bearish funds down to 1.3 for the un-leveraged funds and 0.75 for the leveraged ones.  Both are now at or below their lower trading bands already, a signal which has reliably preceded other intermediate-term lows over the past five years.  During the prior bear market, those ratios dropped all the way down to 0.5 and 0.25, respectively, so while they are extreme in comparison to their recent history, we may have much more of an extreme to endure in the context of an ongoing bear market.

On a short-term time frame, since last summer the market has not reacted well to opening thrusts after already having enjoyed a couple of up days.  When the S&P has gapped open +0.5% or more after two consecutive up days, then buying the S&P on that morning's open and holding through the next day's close resulted in zero winning trades out of 8 attempts, with an average return of -0.9%.  The most the S&P was able to travel to the upside over those sessions averaged +0.4% compared to maximum downside that averaged -1.8% - four times as large.

Going back to the beginning of the history for the S&P 500 tracking fund, SPY, there were 99 of these setups, and it was positive over the next two days 40% of the time averaging -0.3%, much weaker than average during the study period.  If we look only at bear market instances (simply defined as a declining 200-day moving average) then the winning percentage comes out to 23% (7 out of 30) and an average return of -0.7%.

Ignoring the past two up days, if we buy SPY at the open any time it has gapped up +0.5% or more two trading days before an exchange holiday, and then we sell it the day after the holiday, then it showed a positive return only 30% of the time (4 out of 13), and averaged a return of -1.0%, with an average maximum risk (-2.3%) that was nearly four times larger than the average maximum reward (+0.8%).  Each of the last 7 instances dating back to 2000 have given a negative return.

Our most sensitive indicators are neutral at this point, but it may not take much to push the ones for the S&P 500 into overbought territory.  Given the list of negatives we've discussed since late last week, and the statistical tendencies we just went over, if the index pushes up towards the 1300 area over the next two days and generates those overbought readings, I'll likely be selling short the index.