Rush Into Safe Havens Still Evident

09/24/08 9:05 AM EST

Good Wednesday morning...We begin the day with a Buffett/Goldman-inspired gap up opening in the pre-market futures.  We saw a large spike up immediately after the investor's bite out of Goldman after the close yesterday, and the futures have been see-sawing all morning, but are still quite positive.  Foreign markets are showing tepid returns.

Traders are looking for some type of short-term resolution this week, as Congress rushes to "just do something" and pass the initial stages of their stabilization legislation before Friday's scheduled adjournment.  There are some economic stats that may hold some sway in between (home sales today, durable goods and jobless claims tomorrow and GDP on Friday), but they are likely inconsequential compared to the uncertainty of what a bi-partisan government plan will ultimately look like.

That uncertainty is nothing new, we've had wave after wave of it since late last year.  In response, we have seen cash balances grow substantially, which should at some point prove to be a major positive for equities once risk appetite returns.  The latest Data Brief looked at the mirror image of the credit crunch, which was a cash cushion that exists in safer instruments like money markets.

Another related indicator that we can add to the pile comes from the Rydex mutual fund family, where we track the percentage of total index-based assets currently allocated to their money market fund.

On the site, we put trading bands around the indicator, and that does a pretty good job at highlighting times of momentary emotional extremes, and works in the typical contrary manner.  When these traders are so concerned that they put a bunch of money in cash, then stocks tend to rise (and vice-versa).

Over the past couple of days, assets in the money market have snowballed, and now make up more than 43% of the total.  The last time it got this high was 2002:

Money market assets pushed a bit over 50% of the total at the height of pessimism during the last bear market, so history suggests we could get a bit more of an extreme here, but currently it looks like we've already reached one.

Yesterday we briefly touched on the volatility we've seen lately, unprecedented in modern history.  The historical volatility over the past week suggests the S&P will move nearly 80% over the next year, the highest reading since the 1930's other than immediately after the '87 crash.  And the S&P had carved out at least a 3.5% intraday (high to low) range during each of the last six sessions, something never seen since 1982.

In addition, this is only the fifth time we've seen the S&P 500 futures or its tracking fund, SPY, sell off more than 2% from open to close for three straight days.  The others were 10/20/87, 04/14/00, 07/22/02 and 08/05/02.  All were very bullish in the short-term, leading to an average +4% gain over the next three trading sessions.

I don't usually like to make multi-step "crystal ball" types of forecasts, but over the past couple of weeks, we'd gone over the likelihood that we were about to enter a several-stage bottoming process:  a severe downdraft, following by a short-term rally, a re-test of the panic low, then good gains during the fourth quarter.

Despite all of the impossibly unpredictable events to which we've been subject, equities have conformed pretty well to that game plan, and I see no reason to expect different going forward.  If anything, the behavior of the past week strengthens the argument considerably, based on how investors have historically reacted to panics like last week.

The biggest question at this point is whether or not the past couple of days have been enough to constitute the re-test of last week's low.  As I mentioned then, a re-test would almost certainly not involve an exact kiss of last week's low - we would either hold above it, or slightly and temporarily jut below.

The fact that we've really only seen two days of decline, and still remain nearly 5% above Thursday's low makes it a bit difficult to buy into the idea that this was a complete re-test of the low, but it does seem like we're setting up for another attempted up-thrust.

In October 1987, stocks retreated for only two days after the initial surge, then surged again before moving into more of a trading range.  In October 1997, we got really only one day of decline after the initial thrust before another push higher, then a trading range.  In September 1998, we got three days of decline after the initial thrust, then we surged again before moving into a trading range.

That pattern is pretty clear - panic, a quick relief buying binge, one to three days of selling as realization sets in, another buying binge as those who missed the initial low spot their opportunity, then the back-and-forth frustration that hammers out the longer-term low and better intermediate-term risk/reward investment opportunity.

Given what we went over above, I think that's pretty likely here, too.  Unfortunately we're starting out with a gap up this morning - substantial gap up openings are rarely a good time to try to get into short-term long positions, and have been especially deceptive this month.  Of the five times the S&P has opened more than 0.5% above its previous close this month, it has closed higher only once.  And that was September 18th, after the index had lost more than 3% intraday.

What I'll be watching most closely is price behavior after the first 30 to 60 minutes of trading.  If we can hold above the opening prices after that sorting-out period and move on to set higher intraday highs, then I suspect we have even more gains in store and will look to re-establish some long positions as the day wears on.  Ideally we will also see some let-up in safe-haven buying like we're seeing this morning in short-term Treasury Bills.

If we can't hold above the opening prices, then it's much more likely we're facing another "fade" and I would not be at all quick to try to buy into a declining market.