Taking Baby Steps To A Resolution

09/15/08 3:20 PM EST

As of: SPX 1251 HELP  ARCHIVE

One of the remarkable things we're seeing today, among many, is that breadth is absolutely horrid - nearly everything is selling off in concert.  That has pushed the Up Issues Ratio (the percentage of stocks on the NYSE that are up on the day) all the way down under 10%.

Looking back to 1962, I checked for any time the Ratio closed under 10% and the S&P 500 closed at a new 52-week low.  The very short-term was mixed - the index was up the next day 5 of 9 times, averaging +0.7%.  Four of the first five occurrences led to negative results, the last four all led to positive.

After a week, though, 8 of the 9 were positive, averaging a healthy +3.3%.  The average maximum gain during those weeks was +6.6%, well above the average maximum decline of -2.4%.

Six of the instances marked the end of a major decline, or very close to it.  Two, from 1973 and 1974, led to a brief pause then a rollover to even more severe losses.  For those curious, the dates were 08/26/66, 08/29/66, 07/28/69, 05/25/70, 11/26/73, 07/08/74, 09/25/81, 10/19/87 and 08/23/90.

Actually, as I edited this note the Up Issues Ratio just dropped to under 8% as the NYSE TICK printed one of its most extreme negative readings in history (i.e. everything's being sold at once).  Re-running the test above but using that kind of extreme, only two dates emerge:  08/26/66 and 10/19/87...both of which led to ~5% rallies over the next several weeks.

I mentioned the Panic Button indicator in a note earlier this afternoon.  With the further selling pressure this afternoon, it has bumped up a bit more, to 2.8...not quite to the 3.0 level that would suggest that yes, we have finally seen the type of panic that traditionally signals the beginning of a bottoming process.

We're also seeing put volume relative to call volume push higher, a good sign but as noted earlier one that tends to be early.  It will be interesting to see total exchange and off-exchange volume as well - a new record-high in volume would be another bullish sign of purged selling pressure.

I'm pretty certain there will be a number of interesting indicators / studies that pop up tonight.  We also have some major economic data due tomorrow, as well as brokerage firm earnings and the FOMC meeting (and the incessant rumors of financial destruction), so there will be no shortage of things to keep us hopping.  There is also relentless pressure on politicians and government officials to limit the damage, so we have to expect announcements coming out of that group regarding some kind of attempted solution(s) regarding the many holes in the dike.

As I mentioned before the open today, this morning's gap seemed different than others that we've seen lately.  I know that's a dangerous argument to make, but for one of the only times in the past six years, I was not willing to buy into this morning's large gap down.  Given the readings we've seen throughout the day, I'm becoming more confident in the odds I laid out on Friday, giving the highest probability of success to a scenario of extreme short-term, skewed-to-the-downside volatility, followed by a major intermediate-term rally.  Today's events have perhaps hurried that along, and I continue to believe we're headed for a nice long-side opportunity, but I don't see the edge in jumping in with any meaningful position yet.

One of these days we'll probably wake up to a 3% gap up as potential solutions get aired, and that should help firm up a probable bottom.  Until we see some actual solutions (assuming they exist), a more positive reaction from traders or an honest-to-goodness wipeout (I don't think today qualifies yet), I continue to hide in cash.

Panic Starting To Rise

09/15/08 1:35 PM EST

As of: SPX 1251 HELP  ARCHIVE

On Friday, I showed a chart of the Panic Button indicator, a measure that shows stress in different parts of the credit markets.  It's basically a reflection of standard deviation, so a reading of 3.0 would mean that panic is 3 standard deviations away from the norm - a notable event.

The measure has climbed over 3.0 on two separate occasions since the trouble started, those being August 10th of last year and March 14th of this year.  As of Friday, it was under 1.0, a sign of relative complacency that seemed quite odd.

With this morning's movements in the credit markets, we've moved up to 2.6 on the scale, so obviously a big improvement (if you can call it that).  This isn't the exact same component used in the Panic Button indicator, but this morning we're seeing the ratio between the VIX and 10-year Treasury Notes move over the level of 7 that we discussed on July 15th.  It's this kind of movement that is helping to force the Panic Button higher.

So we're starting to see some real concern about the issues being reflected in guides that have been pretty accurate at signaling periods of stress that were about to get some relief.  This doesn't mean we're at an exact low, though.

First, we haven't even reached a real extreme yet.  Second, the market doesn't necessarily bottom immediately.  Since 1950, when the Button hit 3.0 or higher, the S&P 500 was higher a week later "only" 62% of the time.  That's fine, but it's not a big edge.  By three months later, however, it was up 82% of the time (225 out of 275 days) by an average of +6.9%.  Over the past 30 years, it was up 91% of the time with an average of +11.9%.

Some other guides are moving quickly into extreme territory as well.  The Equity-only Put/Call Ratio from the CBOE is currently registering a reading close to 1.20 intraday, one of the highest we've seen (this is an options expiration week, but I don't think the figure is meaningless because of it - market inflection points often occur near option expiration dates).  Again, extreme one-day p/c readings are not necessarily good predictors of an immediate low, but one usually occurs within one to three weeks, fitting right in with the timeframe I wrote about last week.

These kinds of anxiety readings tend to be good heads-up that we're probably entering the end-game of financial distress - some short-term volatility and selling pressure wouldn't be unheard of, but it should lead to a good intermediate-term opportunity.  Perhaps if we roll over into the close, the Panic Button will actually get pressed and we can start to move more constructively towards that fourth-quarter opportunity several other studies were pointing to last week and we touched on again before this morning's open.

A Momentous Weekend

09/15/08 8:15 AM EST

Good Monday morning...We begin the new week with, well, with a world that looks a lot different than it did last week.

Much of what we do is predicated upon learning form history - how the market has performed after certain events, or after various indicator levels.  On balance, it works well because human behavior changes exceptionally slowly, and sometimes not at all.  Einstein once said that the definition of an idiot is someone who does the same thing over and over again, always expecting a different result.  Not to be crass, but there are a lot of idiots with money out there.

But about every generation we run into a situation that is so out of the ordinary, so inconceivable, that there is simply no precedent.  Wars and other political machinations in the first part of the last century triggered several of those.  More recently, much of the trouble has been the result of financial bombs that may not have destroyed lives, but certainly livelihoods.

This weekend was one of those one-in-a-generation events.  We can go over some stats about it, but quite frankly they do not matter.  Just to get it out of the way, let's look at the other times since the inception of the futures markets that the S&P 500 gapped lower by 3% or more, and its performance going forward.

The results are predictably bullish across most time frames.  No surprise there.

Perhaps we should concentrate on the two largest shocks, since I think a lot of folks powering up their turrets today are going to be.  After the -5% open on Black Monday, stocks did not rebound - they fell another 25% into the close.  After 9/11, stocks did rebound hard during the day but fell back and lost about 10% over the next few sessions (check out this comment from January 21st for intraday looks at those prior crashes).

I don't think we will see anything even remotely like 1987...the markets have changed.  Maybe the invention of the CDS market is comparable to portfolio insurance from 21 years ago, but I doubt it.

The fact of the matter is that this isn't like January, when we had an honest comparison to the two other crashes in the past 20 years.  And it isn't like March or last August, when we had a whole hoard of extremes and historically bullish studies on which to base the idea of an upside reversal.  So far (though that could change today), it isn't even like July when we didn't see panic and didn't see panic and didn't see panic, then suddenly got it on July 15th.

What we've seen since '87 is that large gap down openings have been bought aggressively by those increasingly conditioned to do so, and they have been amply rewarded for it time and again.  So we get these one- or two-day ramps higher from large gaps down, that then get reversed themselves and lead to more losses before a more-lasting bottom is found.

With no clear precedents here and issues so complex and deeply ingrained that we cannot know what the implications will be, I will be watching all of the usual panic readings like we went over in the links from the dates above.  The price of the opening bids in stocks will be important guideposts, too...given the size of the gap open, if we go on to set lower intraday lows after the first 1/2 hour or so of trading, then watch out - it could get uglier than anything we've seen in two decades.  If the initial gap holds during the early-morning hours, then we'll probably get the usual one- or two-day bounce that will bring up the typical "was that THE bottom?" questions.

Unlike past panics over the past 6 years, I don't intend to buy into this morning's gap.  That may change (with a tiny amount of capital) if the gap continues to expand to near limit-down proportions, but this one feels different.  The Fed has tapped its chest of surprise moves, unless it takes one more step and begins to accept real estate as collateral.  That should shock the market higher, though the long-term consequences are likely more negative than the steps they've already taken.  The other potential jolt would be the formation of something like Resolution Trust, which seems inevitable at some point.

This is a truly momentous time for financial markets.  In the six years we've been trying to navigate this beast together, I don't believe I've ever uttered such hyperbole, but this is a game-changer for U.S. and world financial markets.  I'm not sure what the landscape will look like a year from now, but it will be a whole lot different than it was a couple of weeks ago.

As I mentioned last week, I placed the greatest odds on us seeing a period of one to three weeks of exceptional volatility with a downward bias, and that seems to have hit with a vengeance this morning.  Now we'll just have to see if this is the kind of event that leads to the strong fourth quarter that was the other part of those odds.

There are a lot of folks out there banging the drum to buy this morning, which puts me at unease (we didn't see as much of that in January or during the other panics), so this is going to be a very fluid situation, kind of like trying to play musical chairs on a blanket laid over quicksand.  I don't think this is yet the time to try to aggressively establish positions - if it's the seminal event so many are trying to make it out to be, then we should get re-tests of this low and more volatility ahead which should present better opportunities than trying to step into the maw of this gigantic unknown.

Unlike the other panics, with this one I'm more inclined to be reactive than proactive.  There is a difference between being inactive because you don't see an edge, and being inactive because of fear.  I try to be exceptionally patient during the former, and work through any emotions during the latter.  Whether we truly have an upside edge this morning is debatable, but the current fear of the unknown seems justified given the absolute scrambling being done at the very highest levels of finance over the weekend, with nobody having any answers.

To reiterate, I'm basing my action (or more likely, inaction) based on the measures of panic we've discussed before and stocks' opening prices.  If we rebound immediately, then I'll be assuming that we're in for the typical 2% - 5% bounce over the next couple of sessions.  If we hit lower lows...then I have no idea.