A Lack Of Panic, Depending On Where You Look

09/12/08 4:30 PM EST

As of: SPX 1251 HELP  ARCHIVE

Well, that was a wild week that many traders, myself included, are not sorry to see pass.  With exceptional volatility, a constant flow of rumors, and price action that didn't flow well from one day to the next, it was tough slogging.

For all that movement, not much was resolved.  We still have outstanding issues with several large banks, brokers and insurance companies, the technical picture of the indices has not been cleared up at all (in fact, it's even more of a mess than it was) and most of our sentiment guides haven't changed appreciably.

There is an odd disconnect between some of the largest financials in the world, and the rest of the market - even the rest of the financial sector.  We're seeing credit insurance on some of these firms widen beyond their prior record highs, yet the rest of the market is stifling a collective yawn.

That can be seen in the Panic Button indicator, something we discussed a couple of months ago to help reflect conditions in the credit market.  The indicator incorporates the TED Spread, Junk Bond Yield Spreads, a ratio of Volatility to 3-Month Treasury Bill Yields and High-Yield CDS Spreads.  All of these spike higher when uncertainty about the economy, corporate outlooks and stock prices are high, and reach extreme high levels only during times of outright panic.

As we can see from the chart, it's currently sitting right around 1.0, a perfectly neutral level anymore.  We'd need to see something closer to 3.0 to get the feeling that traders were really scrambling, and there is scant little evidence of that.

I mentioned this morning that based upon the price patterns we've discussed over the past several days, the odd breadth readings we got yesterday, seasonality (in terms of the Presidential Cycle), and the status of our sentiment guides, I handicapped the probabilities of three scenarios:

1.  One to three weeks of volatility, with a mostly downward bias, then a major rally into the new year: 70%

2.  A rally from here, right through resistance, that continues on: 20%

3.  A complete failure, and entrance into a new bear leg with no meaningful rally: 10%

Given that, the odds of generally rising prices over the intermediate- to long-term was somewhere around 90%, very high even though we haven't seen much sign of panicky readings.  But a number of studies based on different methodologies has pointed to a strong fourth quarter.

The biggest issue is the path to get there, and based on what we've discussed, that path looks littered with potholes.  The chances of us seeing some major volatility, with a downward bias, looks strong over the next one to three weeks.

The indices have been saved almost every day this week after any large gap down open, and today was no exception as they drove prices higher right into the closing bell.  The bets are being laid that at least the Lehman situation will be resolved over the weekend, and possibly Washington Mutual as well.  AIG is still the pink elephant that not many seem willing (or able) to discuss, which is a curious thing.

We're once again handcuffed to the latest rumors and headlines, which makes it exceptionally difficult to have any conviction week-to-week, much less day-to-day.  I continue to see little in the way of solid edges in the short-term, with the most likely next setup being a short trade if we hit some short-term overbought readings while under 1260ish on the S&P 500.

Have a safe and relaxing weekend and we'll see you next week!

One Step Back, Two Steps Forward...Or Is It The Other Way Around?

09/12/08 9:15 AM EST

Good Friday morning...We begin the day with a pullback in the pre-market futures, as traders continue to react to every rumor about vultures circling Lehman and other troubled financials, which is not looking good at the moment.  The morning's Retail Sales figures haven't helped matters.

I've been honest about the fact that I've been confused with the market action over the past week and a half, and have been exceptionally inactive trading-wise because of it.  We'd run into a number of conflicting short-term studies, or days where there appeared to be no edge whatsoever.  Given the volatility, that's unusual, as extreme price moves usually trigger high-probability setups one way or another.

Unlike the handful of other times we've seen intraday volatility pick up over the past year, there has just not been much that I can find that has suggested a tradeable low was imminent.  In fact, over the past few days, we've looked at several price-based studies that suggested that we should see a meaningful rally soon, but not before one to three weeks of extreme volatility and most likely lower prices.

Adding to the confusion is the breadth situation from yesterday - the number of stocks rising versus falling, and the volume flowing into each group.  Normally with the indices all up 1% or more on the day, we would see more stocks rising than falling.  Over the past decade there were 278 days when the S&P 500 rose more than +1.25% on the day, and of those only 9 times when there were more declining stocks than advancing ones (not including yesterday).  Oddly, there were more declining issues than rising ones yesterday, but "up" volume was much heavier than "down" volume.

Part of that could be explained by the number of "other" issues on the NYSE, such as preferred stocks that have been getting hit so hard.  Using common stocks only, breadth on the NYSE was slightly positive yesterday.

Still, dating back 45 years I could find only three dates where the S&P was up 1.25% or more, yet the Up Issues Ratio was less than 45% (meaning that only 45% of all stocks were up on the day) and the Up Volume Ratio was more than 55%.  The dates were 10/20/87, 10/16/89 and 04/17/00.  All three were times when the market got hit hard over a very short period of time and put in a big reversal.  All three led to short-term gains, averaging +2.8% over the next three days.  And all three then rolled over, showing an average -2.0% loss during the following month before rallying again.

Interestingly, it's the same story with the Nasdaq.  Going back to 1984, I could find only three days where the Nasdaq Composite rallied 1.25% or more but the Up Issues Ratio for that exchange was less than 45% and the Up Volume Ratio was nearly 70%.  The dates were 03/22/01, 07/03/02 and 11/27/07, all recent.  The Composite was up over the next few days all three times, averaging +2.4%.  But two weeks after that, all three were negative by an average of -6.0%.

The indices reversed again yesterday after selling off fairly hard, something we took a look at on September 5th.  That study was inconclusive, not supporting the idea that such a reversal was necessarily a bullish event.

Yesterday's action was a little different, in that the S&P reversed enough to close up more than 1%.  Since 1982, when intraday reporting of the day's high and low became more reliable, there were 12 other instances when the S&P dropped 1% or more to at least a one-month low, then rebounded to close at least 1% higher.  The short-term performance of the index was mixed going forward (again), but over the next three months the S&P was up 10 of the 12 times (one was barely negative) by an average of +7.0%.

I don't touch on this often, but with the end-game approaching we also have the Presidential Cycle to consider, which calls for a low sometime in late September.  Going back to 1950, if one had bought during the second week of September and held through the end of the year, it would have resulted in 11 winning trades out of 14 attempts, with a +3.5% average return, +6.5% average maximum gain and -4.0% average maximum loss.  But waiting to buy until three days before the end of the month would have given 13 winners out of 14 attempts, a +4.1% average return and +6.6% average max gain versus a -3.5% maximum average loss.

This feels like one of those critical periods that occur two or three times every year, so other than about 3 1/2 hours of sleep, I've been working straight through from yesterday's close, looking at every angle I could possibly imagine.  As a result of that work (or maybe it's just delirium at this point), I would handicap our three most likely scenarios thusly:

1.  One to three weeks of volatility, with a mostly downward bias, then a major rally into the new year: 70%

2.  A rally from here, right through resistance, that continues on: 20%

3.  A complete failure, and entrance into a new bear leg with no meaningful rally: 10%

If one buys here, closes their eyes, and doesn't open them again until the new year, I think the chances of seeing gains is quite high.  But closing the eyes could be important, since it seems likely that there will be shorter-term losses that would be tough to handle.

I mentioned yesterday that I don't see many reasons for optimism that we've seen an end to the brunt of the selling pressure, and that's still the case.  I'm approaching this market with kid gloves, not wanting to risk capital in a tape that has no solid short-term edge and is almost completely wed to the constant rumors of takeovers, takeunders, bailouts, failures and whatever else.

This is Friday, and we've had a very consistent pattern of announcements coming out after the close on Friday or on Sunday afternoons, so with the recent death-spiral in Lehman and Washington Mutual, traders will be anticipating resolution of those issues over the weekend.  Whether that means they buy or sell today, I'm not so sure.  What I am sure of is that I don't want to anticipate much at this point, and am in more of a reactionary mode until we can get some things together that points to a better edge, much like we'd had a handful of other times over the past year.