Double Reversal Could Be Good...Or Bad (Ugh)

09/08/08 3:35 PM EST

As of: SPX 1251 HELP  ARCHIVE

This morning we went over the latest Signpost study that took a look at all other 2% or larger gap up openings in the S&P 500 tracking fund, SPY (click here to view study details).  While the day of the gap was a toss-up as to whether it would close above or below the open, the next few days were generally weak.

Furthering that a bit, out of the 18 times that it gapped up 2% or more at the open, it reversed enough during the day to close at least 1% below the open on five occasions, which it is threatening to do today barring a continued late-day rally.

The next day, SPY was up 2 times and down 3 with an average return of -0.3%.  By two days later, it was up only 1 time and had an average return of -1.7%.  If you had bought at the close that day and held for two weeks, then you would have had 4 winning trades out of the 5, with the winners averaging a hefty +3.4%.

Interestingly, the one two-week loser was the one trade that showed a positive two-day return...meaning that in the instances that SPY dropped in the short-term, it rallied over the next couple of weeks, but when it rallied right away, it gave those gains back.  We can't rely too heavily on just a few instances, but it was worth mentioning.  For those curious, the dates were 10/08/98, 12/12/00, 07/19/02, 04/09/03 and 12/14/07.

If we look for times when the index suffered a double-reversal, there wasn't much of an edge present, but I suppose it would depend on how you define "reversal".  I checked for any time the index dropped 1% or more during the day, then rallied to close at least 1% above the low (like it did on Friday).  Then then next day, it must have rallied at least 1% above the prior day's close at some point, then reversed to close at least 1% below its high...like today (maybe).

We've seen this pattern three other times since the highs last summer, and they were all relatively close to intermediate-term turning points:  08/13/07, 02/19/08 and 07/14/08.  As we went over in the latest Signpost study regarding 2% gaps, the short-term was pretty dicey after those instances, before the market found its footing and worked higher.

Over the past 15 years, such double reversals led to positive returns over the next three days 58% of the time with an average of +0.8%, about in line with random.  The one-month returns were up 64% of the time with an average of +1.5%, a little better but not really significant.

If we stipulate that yesterday's low was the lowest low in at least a month, however, then things change a bit.  Three days later, the S&P was up 10 out of 11 times by an average of +3.0% as traders jumped on the idea that the worst was over.  But after those few days were past, the next couple of weeks were positive only 3 times and the average return was a dismal -1.6% - meaning those jumping on the possible upside reversal theme often got whacked.

This is a really tough juncture, and I'll be perfectly honest in that I'm not quite sure how to handle it, so I'm hiding in cash.  The selling pressure we saw today right from the open after such a large gap up tends to lead to more short-term selling pressure a high percentage of the time.  But when it has occurred after an upside reversal from a low like Friday, then it has led to very positive returns.

We can read something bullish or bearish into that, depending on our bias at the time, and that's not much use to me.  I prefer clear-cut edges that are unequivocal.  We never get "perfect" setups, but I require more than this to risk capital.  With our shortest-term guides mixed in neutral, and most of the intermediate-term ones as well, this volatile price action isn't giving me much of a clue and I prefer to sit it out until it does.

Gaps And The Changing Of Sentiment

09/08/08 9:15 AM EST

Good Monday morning...We begin the day with a major pre-market rally in the major futures indices based off the weekend news flow.  Commodities are rallying almost across the board, and foreign markets have enjoyed major rallies of 3% - 5%.

Normally on a Monday morning after a wild week, I would go over data released over the weekend, such as action from small options traders and the Commitments of Traders report, or perhaps review some of our more consistent shorter-term indicators.

That's pointless this morning, as the market is trading purely based off the Fannie Mae and Freddie Mac takeover/bailout/whatever-you-want-to-call-it.  Like usual, I'm not going to expound on my ideas about whether the FNM/FRE bailout is a good idea from a fundamental, political, economic or social point of view.  My only concern is trying to assess the impact on market sentiment, and what it may mean for us going forward.

This type of market event has the potential to completely change investors' perceptions and lead us to the promised land of a bear-market low.  There are several problems with that assumption, the two largest of which are 1) sentiment wasn't all that extreme heading into the weekend.  We had the potential for some extremes with Friday morning's test of the July low in the S&P 500, but the subsequent bounce prevented any true extremes from forming, and 2) we've already seen a handful of these historical events over the past year, and we continue to hit lower lows.

As to the first point, on Friday morning we went over a few indicators that confirmed the mixed-up nature of most of our others - while signs of speculation have started to pull back (evidenced by a dearth of trading volume in penny stocks), it hasn't dried up completely (as shown by a spike in leveraged Rydex mutual funds...which actually looks pretty smart at the moment), and we're still seeing many indicators far, far from what we typically see near bear-market intermediate-term lows (which we see by "smart money" corporate insiders continuing to hold off buying their own stocks' shares).

As to the second point, the most succinct review I've seen comes from Barry Ritholtz of The Big Picture, if I may borrow his post here:

The last time the S&P gapped up 2% or more from a previous day's close was on March 11th when the market was grappling with the Bear Stearns bailout.  The market liked what was transpiring, and the S&P tracking fund, SPY, went on to gain almost +1.5% from the open to the close before pulling back in the ensuing days.

The latest Signpost study takes a look at all other 2% or larger gap up openings in SPY (click here to view study details).  From the table, we can see that buying at the open and holding for the rest of the day was mediocre, giving 9 winning trades out of 18 attempts and basically breaking even money-wise.  Holding one more day led to two less winning trades, and an overall loss of more than $500 per $10,000 invested in shares of SPY.

Over the next two days, the average maximum gain in SPY was about +1.5%.  If we hit that this time around, it would mean a move to about 1295 - 1300 in the S&P 500 index, which has proven to be a sore point for the bulls over the past month.

So in the short-term, buying these big gaps was not usually the best idea.  Longer-term, it was more feasible, with positive returns after a month 67% of the time and a nearly $5600 gain on those $10,000 trades of SPY.  More impressively, if you would have waited a day and then held for three months, you would have netted $8,200 and had 13 winning trades.

There were only three times we saw a 2% opening gap the day after the S&P had hit at least a one-month low the day before, which were 09/24/01, 08/17/07 and 03/11/08.  Except for after 9/11 the other two were of questionable short-term value, but excellent heads-up that an intermediate-term low was at hand.

Unlike what we saw those other times, and as we touched on earlier, we are not entering this morning's gap coming off any kind of true extreme in pessimistic sentiment.  Sure, we saw prices get hit hard and the Nasdaq 100 was close to suffering (almost) five consecutive 1% daily declines, which in and of itself usually leads to short-term bounces, but we hadn't recorded many historical extremes in investor behavior, so I'm not sure just how comparable this morning's gap is to those others.

Mr. Ritholtz summed up my thoughts pretty well - these kinds of weekend jolts have carried through OK in the short-term, though they have seemed to have less and less staying power as each one gets unveiled.  The early moves in Treasury Notes and the Dollar are already reversing a bit.  I'm not quite sure how this weekend's takeover is bullish enough for equities to spur a multi-billion dollar gap up opening, so my trader's inclination would be to short the snot out of it.  I can't really justify that stance objectively, so I'm going to continue to trade very conservatively until I see a better risk/reward setup, which may not come unless/until we approach 1300 on the S&P.