Not Convinced We've Seen Enough

09/10/08 3:30 PM EST

As of: SPX 1251 HELP  ARCHIVE

After a rocky first couple of hours, buyers have stepped in and taken the major equity indices to their highs of the day.  Despite flat Oil prices, energy-related stocks are leading the S&P 500 higher, accounting for 6.5 of the roughly 19 points the index is up at the moment, twice the contribution of any other sector.

This morning we touched on a few of our guides that had triggered extremes yesterday, such as the Cumulative TICK, Rydex Beta Chase Index, Stock / Bond Ratio, Equity-only Put/Call Ratio, Short-term Indicator Score and a composite of inverse ETF volume.  All of them argued for a temporary reprieve from yesterday's selling pressure.

I wasn't buying it, it part due to the gap up opening.  Every time this year the S&P sold off 2% or more then gapped up the next morning, the index closed below the open.  Perhaps today's performance is an initial sign of a change in character, but it has a lot more work to do before that'd be a high-probability conclusion.

When we check for any time the S&P 500 dropped 3% or more to at least a one-month low, then rallied at least 1% the next day like it's on track to do today, we get 12 prior occurrences dating back to 1950.

Over the next month, the index was positive 5 of the 12 times with a flat overall average return.  All of the five positive occurrences gave back their gains within a week or so later, except one that marked a major market low.

But waiting for a month before buying, and then holding for a month proved to be a much more successful strategy.  All 12 instances led to positive returns, averaging a hefty +4.6%.  During those trades, the most the S&P went against us on average was -2.4% compared to a maximum gain that averaged +6.0%.  Holding for three months led to 11 positive trades with an average of +7.2%, an average max loss of -3.1% and an average max gain of +11.2%.

UPDATED NOTE AFTER THE CLOSE:  I re-did the figure using a 0.5% gain instead of a +1.0% gain due to the late-day sell-off.  Over the next month, the S&P was up 8 times out of 18 instances, still with a flat average return.  But buying after a month and holding for a month led to 17 winners out of 18 trades, with an average of +3.5%, so the same general results held true despite today's smaller percentage gain in the S&P.

That's a pretty sizable upside edge, but we had to wait for a month before taking the trade.  It's interesting that this fits in with the three-day reversal pattern we went over yesterday.  In the past when the S&P has carved out a pattern like it did Thursday through Monday, then suffered a day like yesterday, it has generally led to weakness over the next one to three weeks, followed by very strong gains.

As it stands right now, based on the relatively neutral nature of most of our intermediate-term guides and the studies we've discussed over the past couple of days, I'm more inclined to sell short the next over-bought, over-enthusiastic rally than I am to try long trades, particularly if those conditions trigger while the S&P is under 1265ish.

On a side note, today is the one-year anniversary of the managed account programs that we started in partnership with Global Investment Solutions.  It's been possibly the most challenging year in history for many funds, both public and private, so nothing like a little trial by fire to get things started.

We were fortunate enough to generate double-digit positive returns with minimal drawdown (net of fees) over the course of the year, mainly by trading infrequently, in small size, and cutting off losses quickly, and I don't see that style changing over the next few weeks.  My hope is that after a possibly harrowing upcoming month, we purge some of the lingering problems, the banks that need to fail are allowed to fail, and we have a more "normal" fourth quarter, as I'm sure every other fund manager is praying for as well.

For additional performance data or to request more information on the accounts, please contact Roger Kliminski, principal of Global Investment Solutions.  He can be reached via email at roger@globalinvestsolutions.com, or via phone at 1-866-547-3123 (toll-free inside the U.S.) or 1-949-660-7960 (for those outside the U.S.).

Some Short-term Extremes, But Will They Matter?

09/10/08 9:10 AM EST

Good Wednesday morning...We begin the day with a gap up opening in the pre-market futures, but based on their action this morning that could change quickly.  We've gone from a gap down to a large gap up to a large gap down to the current gap up as the rumors swirl anew on Wall Street.

I noted yesterday that selling pressure like we've seen should trigger some extremes, at least among our more sensitive indicators.  Indeed, the Cumulative TICK fell to one of its lowest levels yesterday, which wasn't the only one of note:

*  The Rydex Beta Chase Index has sunk under 0.25, meaning that traders in that family of mutual funds are more than four times as likely to trade a "safe" fund as a "risky" fund, a sign of severe risk-aversion.  Figures this low have been good predictors of short-term rebounds, with the S&P 500 up the next day 74% of the time (17 out of 23) with an average of +0.8%, dating back to 2000.  Even a week later, it was up 70% of the time and sported an average of +1.2%.

*  The Stock / Bond Ratio has dropped to -2 standard deviations, hinting that stocks have become under-valued.  Over the past five years, this kind of extreme has led to positive one-week returns in the S&P 76% of the time averaging +1.9% and one-month returns 85% of the time (32 out of 37 days) averaging +3.5%.  Historically, I would prefer seeing something closer to -3 in the ratio, which has an excellent record at coinciding with intermediate-term stock market lows dating back four decades.

*  The Equity-only Put/Call Ratio almost hit 1.0 yesterday (meaning there were almost as many put options traded as call options).  A huge chunk of that was due to trading in Lehman options, so we may have to discount the importance of the reading, as much as I hate making excuses for indicators.  Also, the moving averages of the ratio have only now begun to cycle down from modest overbought readings, suggesting we have a long ways to go.  But taken at face value, one-day readings as high as yesterday's have led to positive one-month returns in the S&P 77% of the time (23 out of 30) averaging +3.3%.

*  Our Short-term Indicator Score surged to 75% yesterday, one of the highest readings we've seen.  Since 1999, it has reached this level 15 times, leading to a bounce in the S&P the next day 67% of the time averaging +0.7%.  Over the next week, the S&P was up 13 of the 15 times averaging +1.8%, with the only exception being the days right after the 9/11 tragedy.  It has happened twice so far this year (on March 10th and June 11th), leading to around a 2% jump over the next few sessions. 

*  Volume in the major inverse ETFs (that profit on a market decline) has expanded quickly over the past few sessions, reaching 110 million shares a couple of days ago.  It receded just a bit yesterday but remains elevated.  As the chart below shows, jumps in volume (shown on an inverse scale) have preceded at least short-term lows in the S&P with fairly good consistency over the past year.

When the S&P gaps up after losing 2% or more the prior day, buying the gap and holding 'til the close has resulted in only 52% winning trades over the past 15 years.  All seven times it happened this year, the S&P went on to close lower than the open, so obviously chasing the gap open has not been a great idea lately.

When the S&P gaps down after a day like yesterday, however, it has proven to be more of an indication of exhaustive selling, and the index closed higher than the open five of the six times it's happened since last August.  Obviously, I would prefer a gap down here instead of a tepid recovery.

I mentioned yesterday that this was a treacherous tape since it is so subject to major headline risk both ways as rumors of failures, bailouts and takeovers run through the Street, as we're seeing with Lehman (and Washington Mutual and AIG). 

When you see "safe" funds getting hit the hardest, someone, somewhere is taking major losses.  Even the relatively staid Wells Fargo just took a $400 million write-down from losses on preferred stock (due to Fannie and Freddie).  Preferred stocks are a hybrid - they have some characteristics of bonds yet are priced like stocks, and they are senior to common shares in liquidations and bankruptcies, but junior to other forms of debt such as corporate bonds.  They are often pitched as a more conservative option to common shares.

Consider two exchange-traded funds that concentrate on preferred shares (and which don't even hold large amounts of preferreds from Fannie and Freddie) - PGX, down 12% over the past two days, and PFF, down more than 10% over the past few.  Who are the largest holders of PFF?  Merrill Lynch, Fifth Third, Wachovia, Genworth and Citigroup.

These are tiny positions for them, but it highlights the circular nature of the trouble here.  Some of the largest issuers of preferred stock are banks, and banks are also some of the largest holders of other banks' preferred shares, and preferred shares in general.  This is the problem with the Fannie/Freddie debacle - there is a trickle-down effect and firms are taking major losses that haven't been considered yet.  Over the next few weeks, more bodies will be floating to the surface.

It's possible that with the action yesterday and over the past week, much of this trouble has been priced in.  Based on our sentiment guides, which are still mostly neutral, it would be difficult to make that argument.  Yesterday went a ways towards changing that, as we discussed above, but our Smart Money / Dumb Money Confidence for example is still well within neutral territory.

We're probably close to a bounce here, based on what we went over above.  But I'm not trading it - if we were gapping down instead of up, then maybe I'd take a potshot with a small amount of capital.  The tendency for the market to respond well to gap up openings after major losses like yesterday has not been good recently.  If we are able to bounce today, then maybe that will be an initial indication that the pattern so far this year is changing for the better.  I'm not counting on that, but you never know.