Bullish Factors Persist; Intervention Is A Wild Card

09/19/08 9:05 AM EST

Good Friday morning...We begin the day with a monstrous gap up in the pre-market futures as traders grapple with the bevy of "solutions" being introduced.  Foreign equity markets were almost all up an incredible 5% - 10%.

Last week, we went over a few different studies that indicated we should see some extreme short-term volatility, with a marked downside skew, that would then likely lead to higher intermediate-term prices.

It didn't take long to start to pan out, as the volatility beginning on Monday was as high as we've seen in many years.  That has continued so far the bulk of the week, and we've seen yet more studies that would lead us to the same conclusion.

On Monday, we looked at what has happened when the S&P gaps down -3% or more, which had a definite upside bias over the following month.

On Tuesday, we went over the Panic Button, which was pushing up above extreme territory for the first time in months, and was a missing piece of the "bottoming" puzzle that was curiously absent last week.  We showed the prior dates we've hit such an extreme, and they were very good in the intermediate-term.

On Wednesday, we again discussed the (even greater) extreme in the Panic Button, along with the surge in NYSE total volume (even without AIG and Lehman included) and the explosion in the number of securities hitting new 52-week lows on the NYSE.  Again, all had bullish connotations.

Yesterday, we pretty much reached the point of no return - we were either about to follow through on those historical precedents and rally 3% - 5% in a very short period of time, or we were going to crash.  And I don't take that latter suggestion lightly, it's something I've never given serious consideration to during the past six years.

The latter situation looked more and more likely heading into the afternoon, then a remarkable series of announcements brought us back from the edge of the cliff.  And it truly was the edge - an additional 100-point loss in the S&P was not out of the question heading into option expiration.

The problem was that equities were not responding to the marginal improvement in the credit markets, with the Panic Button indicator dropping from its all-time high of 9.5 on Wednesday to a still-elevated-but-at-least-improved 3.5 yesterday.  Given this morning's indications, it's back to 1.0 as I type.

Yesterday's behavior was notable on many different levels.  We've posted a couple of new Signpost studies that look at reversals from a low, and the number of new lows on the NYSE.  For the third day in a row, more than 30% of all issues on the NYSE hit a new 52-week trough, something we haven't seen since 1974.

If you go to the Signpost section and look at the study for the number of new lows, you'll see that we're limited to a very low number of historical precedents (only five), but they were unequivocally bullish - all five were higher one month later by an average of nearly 6%.

Here's a chart taken from that study:

That's also the case with the reversal pattern, that looked at times the S&P has dipped to a new 52-week low and lost 1% intraday, then reversed to close +2% higher.  Again, very bullish returns in the short-term (up 90% of the time by an average of +2.7% one week later) and the intermediate-term (up 90% of the time by an average of +7.7% three months later).

With both studies, and the ones we discussed earlier this week and last week, there is an awkward time period of several weeks after these events.  While it's tough to make a total generalization, what we very often saw was a huge kick-off to the upside over the next one to five trading sessions, then a fallback that tested the low.  "Testing the low" is subjective, as we didn't often see the index dip back to exactly kiss its prior closing low, but it was rare to see the market just never look back and keep chugging to the upside.

Since last week, based on the studies we went over, my thought was that we would see one to three weeks of excessive volatility with a downward bias, a huge upthrust that would help anchor the bottoming process, then one to three addtional weeks of choppy trading with a downward bias that tested the low and helped us put in the best risk/reward opportunity for intermediate-term trades heading into the fourth quarter.

That's a "crystal ball" kind of forecast that I usually shy away from - there were a lot of "ifs" that had to happen to make it play out anything like that - but so far the market has been responding pretty close to historical norms.  Yesterday was very iffy, we were balancing right on the brink of collapse, but with the late-day reversal I feel comfortable in continuing to rely on the precedents we've discussed.

We continue to be hamstrung by headline risk, meaning that traders will still react in knee-jerk fashion to the latest news coming across the wires.  With the extreme flux in the credit markets, the great number of financials subject to one rumor after another, and the constant (and sickening) grand-standing by politicians, it will continue to be a volatile environment.

We also have to be cognizant of some of these government interventions.  Some of them are good (the possible formation of an RTC-type entity, and just about anything that helps the integrity of money market funds), some are horribly misguided and will no doubt backfire (the ban on short-selling).  That last one is a real doozy, and has an untold number of repercussions.

The initial jerk higher in response to the ban on shorts is understandable - the aftermath will not be.  I'm not going to get on my soapbox about what a bone-headed move it is, but I do believe it's going to ultimately result in more downside pressure than we would have otherwise, perhaps significantly so.

I'm not sure how much upside is left after yesterday and today's morning gap - we could fade immediately on a sell-the-news reaction, or we could shoot 5% higher based on the fear or actuality of traders covering short positions.  I don't know - we've never seen this in such a large market in modern history, and I can't imagine what to expect.  I do think, however, that the typical pattern will play out, and after an initial thrust we will get the pullback that will lead to some excellent long opportunities heading into the fourth quarter.

FWIW, based on the complete unknowns here, I'm moving our signal strength for the short-term back to neutral based on the futures being up 65 points.  I'm not sure how applicable it is in this environment, but a previous Signpost study looked at 2% or larger gaps up in SPY, and it wasn't a great short-term signal.