Watch For A Post-Crash Letdown In The Coming Days

09/30/08 3:40 PM EST

As of: SPX 1270 HELP  ARCHIVE

With the gap up opening this morning, one of the things we wanted to look for was a higher intraday high after the first hour of trading.  Like a mirror image of yesterday, such a move should lead to a move into the close in the direction of the breakout, and we're once again seeing that trusty pattern ring true.

This morning we re-iterated some of the extraordinary readings that triggered yesterday, and so far we're seeing the typical aftermath.  As the latest Data Brief laid out, and we've discussed numerous times, the market has a strong tendency to bounce back in the very short-term from readings like yesterday.

Now's where the even more difficult work comes in.  Taking those same crash scenarios in the Data Brief, if we had waited for two days after the crash to buy into the DJIA, and then held on for a few days, we would have had zero winning trades out of the nine attempts, and we would have been sitting on an average loss of -6.2%.

This is an important aspect, and I think it will prove out this time around as well, at least to some degree.  Waiting until the smoke clears to buy into rebounds like this has almost universally been a mistake - you either have to buy into the teeth of the decline (not necessarily a good strategy) or you wait until after the initial knee-jerk reaction has run its course.  I have been banking on that pattern to repeat to some degree, so have been holding off on building anything other than short-term trading positions.

With the trend day higher today, our shortest-term guides are pushing towards overbought territory, and another up day tomorrow should give us a slew of optimistic extremes.  Combined with the usual back-and-forth parrying after post-crash rebounds, I suspect stocks would not be able to hold further gains.

Given everything we've discussed over the past few weeks, the market has been responding in almost classic fashion, which helps to bolster the view that we should see decent gains during the fourth quarter.  Yesterday should have marked the end of the bulk of the selling pressure, and even if we do get the typical post-crash letdown in the coming days, I'm not expecting Monday's low to be meaningfully violated (and if so, quickly regained).

Politicians Are Watching The Market; The Market Is Watching Politicians

09/30/08 8:50 AM EST

Good Tuesday morning...We begin the day with a rally in the pre-market futures, with the major indices indicated to open 1.5% or more above yesterday's closes.  They have been volatile, so that will likely change before the open.  There was some stiff selling pressure in the closing minutes yesterday, so don't be surprise to see odd divergences among related contracts, such as futures, ETFs and cash indexes.

Yesterday, we looked at a couple of remarkable developments, such as the never-before-seen volume skew to the downside on the Nasdaq exchange, and the historically notable skew on the NYSE.  At one point yesterday afternoon, "down" volume was overwhelming "up" volume by a 50-to-1 ratio.

Short-term returns following other such days of lopsided selling pressure were consistently positive, as were the only two other times that the S&P 500 dropped 5% or more to a new yearly low (on 05/28/62 and 10/19/87).  In a Data Brief yesterday afternoon, we looked at other plunges in the DJIA over the past 100 years, and reached a similar conclusion.

The selling pressure was so great, and so broad-based, that only one stock among the S&P 500, Nasdaq 100 and DJIA managed to hold in positive territory.  Campbell Soup, with its "massive" gain of $0.12, stemmed the S&P's slide by 0.003 index points.

Going back to 1990, I can't find any other day where only one stock in the S&P rose.  Here are the number of advancing stocks in the S&P for the other days the index lost 5% or more:

10/27/97:  27

08/31/98:  27

04/14/00:  13

09/17/01:  46

The only comparable day was February 27th, 2007 when we had a scare with a massive drop in the Chinese market.  On that day, the S&P didn't lose 5% of its value, but only two companies closed positively (RadioShack and Questar).

For the NYSE exchange, yesterday saw the most declining stocks in history.  Of course, stocks have been added to the exchange over the years, so we can't really use absolute numbers and compare them to decades past.

Using a ratio, fewer than 6% of all stocks rose yesterday.  Over the past 40 years, there have been five other days with this bad of a reading:

10/09/79 (the S&P was coming off of a high, and it led to another two weeks of selling pressure before a bottom)

10/16/87 (the day before Black Monday)

10/19/87 (Black Monday, market essentially bottomed that day)

10/27/97 (Asian crisis, market bottomed that day)

09/15/08 (credit crisis)

We're still seeing signs of severe stress in the credit markets, which we must see change to have any hope for a lasting rally in equities.  The overnight bank lending rate that we use in the Panic Button indicator has surged to 6.88%, about 6.4% greater than short-term Treasury Bills.

That spread has averaged about 0.6% over the past 20 years, and this morning's reading is about 7 standard deviations from the norm.  If my math is right, then that would mean we should only see this about once every 250 billion trading days.  So at least we have that.

This is also called the "TED Spread", and while it has become more popular as an indicator among casual market-watchers, I don't think that makes it any less useful.  The main problem with the current market is credit stress, and this spread is as good an indicator as any I know.

This morning we hear the usual shrill cacophony of advice..."don't catch a falling knife" (I'm really sick of this one - can't anyone come up with a better cliché?), "oversold can get more oversold", "value stocks can become value traps" on the one hand, and on the other we have those pointing to the new record-high close in the VIX and pounding the table that the bottom has to be in.  This is the same thing we've heard after every big decline. 

I rely on behavior and history.  And they are both very clear that stocks have a strong tendency to snap back after stampedes like yesterday.  There may be a day or so of further selling pressure, and it can be severe, so that must be factored in.  That doesn't mean you wade in with 100%, but rather use the volatility as a factor in position sizing.  Can the S&P move up or down 10% today?  Sure, so cut position sizes so that a 10% loss wouldn't make more than an acceptable dent in total equity.  It's not rocket science, but volatility like this is what creates edges.

Despite all the remarkable news events of the past two weeks, the market has pretty much adhered to the game plan we discussed a few weeks ago.  Yesterday's decline was obviously stunning and outside the norm, but historically it was not that unusual to get an undercut of the low before a more lasting bottom was formed.  That's the main reason I did not want to rush in to buy intermediate-term positions after the initial rebound from the mid-September panic.

There were a number of studies we discussed earlier this month suggesting that we were within one to three weeks of another bear-market intermediate-term low that should lead to good gains during the fourth quarter.  Yesterday's session helped to hurry that along, and I see no reason to abandon the idea at this point.  I have no clue what to expect from Congress or other government entities, particularly if we continue to decline this week, but I do expect this week to mark the end of the brunt of the selling pressure on a closing basis.

I was more interested if we would have happened to see a gap down this morning, or at least an early-morning flush lower that began to reverse.  That would be a better time to try to add some long exposure on the idea that markets tend to partially reverse extremes like yesterday, and perhaps we'll still get it if the morning gap up can't hold and the early buyers rush to cash out.  This is month- and quarter-end, and fiscal year-end for some firms, so volatility should remain high.

While the pattern could be looser than normal due to all the cross-currents today, given the size of this morning's indicated gap, I'll be watching the high and low set during the first hour of trading.  If we go on to set higher intraday highs later in the morning, then we should see still higher prices going into the close.

As far as surprise announcements, we should expect the unexpected if stocks continue to fall - a special Congressional re-vote, a total ban on all short sales, a coordinated worldwide cut in interest rates, an indefinite suspension of mark-to-market accounting, a cancellation of CDS contracts, a government guarantee of deposits and debt ala Ireland (which saw its banking index surge 20%...and with another nod to the law of unintended consequences, the banks on its no-short list are up "only" 16%).  Nothing can be ruled out when politicians and financiers become desperate.  And if you think they're desperate now, just wait until the S&P is down another 5%.