A Little More Follow Through Should Lead To A Bounce

09/02/08 3:30 PM EST

As of: SPX 1251 HELP  ARCHIVE

Despite the huge drop in Oil over the weekend and into this morning, buyers of stocks have not been able to capitalize on the potential positive ramifications.

Over the past five years, big drops in the price of Oil have tended to coincide with a rally in equities, so this is something of a change.  Out of the 27 times Oil has declined 4% or more in a day, the S&P 500 showed a positive return those days 21 times, a success rate of 78%.  Going back further than five years showed inconsistent results.

Focusing on those six failures (most similar to today), we see that stocks did tend to snap back in the short-term.  Over the next three trading days, the S&P showed a positive return five of the six times, averaging a healthy +1.9%.  The one exception was a minor loss of -0.1%.

Today's reversal surely looks ugly on a chart, but as we've discussed repeatedly over the years, "ugly on a chart" doesn't often manifest itself as lower prices going forward.  Let's check the history of the S&P 500 tracking fund, SPY, to find any other time it has gapped up +0.75% or more at the open, rallied to at least a two-week high, then collapsed to close in negative territory on the day.

Over the past 15 years, there were 13 occurrences, and they led to a rebound the following day only 5 times, with an overall average return of -0.4%.  After that immediate downside follow-through, however, if we bought at the close the next day and held for a week, then we would have shown 11 winning trades out of the 13 opportunities, and an average return of +1.8%.  The average maximum gain over the next week (+2.8%) was more than twice as great as the average amount that the S&P lost at its worst at any point during those weeks (-1.1%).

We're seeing quite a tug-of-war between sectors as the day wears on.  Banks and Retail are both holding strong with 1%+ gains on the day, while Energy and Technology are getting hit with -1% or greater losses.

Looking at other times the BKX Banking Index has rallied 1% or more on the same day the Nasdaq 100 has lost 1% or more didn't lead to anything conclusive.  The S&P 500 was positive those days 52% of the time (36 out of 69 instances) with a flat average return.  The S&P's performance over the next several sessions ticked up just slightly, but was perfectly in line with random.  I can't find any predictive edge in the sector rotation's impact on the broader market.

The technical picture of the S&P appears neutral so long as we remain mired between 1250ish and 1300.  I could make a fairly solid technical case for either a bullish or bearish resolution, which means nothing at all - I'm just as willing to sell short as go long in these environments, with no preference either way.

Our shortest-term guides have spent the day cycling out of their overbought conditions from last week, and most are either at or close to oversold territory already.  Another modest down day would take us towards possible support at the lower end of the recent trading range, it would almost certainly push our short-term models firmly into oversold territory, and given the stats we went over above, there is some precedent for a snapback from price patterns like this after a bit of downside follow-through.  I'm not sure how much longer we can count on the market bouncing from obvious support levels, but another down day might make a long-side shot worthwhile.

Oil Move May Trump Seasonal Follow Through

09/02/08 9:15 AM EST

Good Tuesday morning...We begin the new week with a large gap up opening in the pre-market futures as Oil is getting slammed hard, the Dollar is rallying and foreign markets show solid gains.

Late last week, we went over some data that suggested that equities should pull back imminently, through Friday and possibly early this week as well.  Based on how options traders were behaving, and the price pattern that the S&P 500 had carved out, the probability of the mid-week push higher being sustained looked quite low, especially as the index kissed the 1300 - 1305 area that looked like a nice spot to sell against.

Friday's selling pressure went a ways towards alleviating the negatives that had built up, though there is still a bit of left-over negative seasonality.  Over the past 58 years, whenever the S&P has lost 1% or more the day before an exchange holiday, the day after has shown a positive return only 36% of the time (7 out of 19 instances), and with an average maximum risk (-1.5%) that was three times greater than the average maximum reward (+0.5%).

With Oil getting crushed over the weekend, however, stock traders are taking that as a major positive and have bid up the pre-market futures.  Taking the same examples as above but looking only at the instances when the S&P gapped up +0.5% or more at the open following the holiday, then the index closed in positive territory 5 out of 7 times by an average of +0.7%.

Ignoring Friday's performance, if we just look at any time the S&P gapped up +0.5% or more the day following an exchange holiday, we see that it closed higher than the open 11 out of 22 times with an average return of exactly 0.0%.  It doesn't get much more neutral than that.  Three trading days later, it was up only 40% of the time with an average of -0.2%, so a slight negative skew looking out just a bit longer.

Data released over the weekend was mostly inconclusive again.  Small options traders continue to show some confusion in their behavior - they have pulled way back on their purchases of speculative call options, which normally occurs right near market lows.  That's typically a very good sign, but it has almost always been accompanied by a rise in protective put purchases as well...and we're still not seeing any signs of that.  Last week they spent only 20% of their total volume on buying put options, far from the 25% or higher we've seen near past market bottoms.

The latest Commitments of Traders report did show something of a change for the better among small speculators in the equity index futures.  As of last Tuesday, those traders were holding a nominal $8.6 billion net long position in S&P 500, Nasdaq 100 and DJIA contracts (including both the full and e-mini contracts), which was down a whopping 31% from the prior week.

Small specs are now holding one of their smallest net long positions in the futures since the year 2000, other than September 2007 and January 2008.  I've noted often how I no longer place nearly as much weight on their data as I used to as I've found it less consistently predictive than in the past, but I still pay attention to it and I would consider this a positive for the market.

I mentioned last last week that given the negatives that had built up, I wasn't counting on the rally to last.  Friday's selling pressure moved our shortest-term guides out of overbought territory and they are now all neutral.  Heading into the new week, I felt that some additional short-term selling pressure was likely given the market's propensity to follow through on weakness following an exchange holiday, but the huge move in Oil and the large gap up open have me backing off that idea.

The technical picture in the S&P looks about as neutral and mixed up as it can get, and our indicators aren't much different.  I generally look to fade (i.e. bet against) a large gap open on the first day of a week since it tends to be more emotionally driven, but if we continue to make higher intraday highs after the first hour of trading I will no longer be so keen to sell against this 1300 - 1305 area on the S&P.