Can The Pattern Hold?

10/01/08 8:55 AM EST

Good Wednesday morning...We begin the day with selling pressure in the pre-market futures, though the indices are well off their lows of the morning.  We're still subject to some headline risk as Congress debates another bailout plan, but much of that uncertainty should be priced in and we will finally be able to trade on more normal terms going forward.

During the past two weeks, we've had to step away from some of the usual types of analysis we do and concentrate more on the credit markets and subjective judgments.  Instead of studying put/call ratios, we've been looking at Libor rates; instead of monitoring Rydex mutual fund flows, we've been watching the pricing of bond funds.

That's not by choice or design - it's been required in an attempt to sidestep some of the pitfalls of trading a tape unlike any of the past 20 years.

One of the myriad causes of the recent bank failures has been a classic "run on the bank" where depositors pull funds en masse and put them into a (perceived) safer institution.  The introduction of online banking has helped that along, as customers can move funds with the click of a button.  This quick transfer of funds is the major reason why Washington Mutual and Wachovia had such quick spirals downward.

To help stop that behavior, the government is considering raising deposit insurance from $100K to something more like $250K.  The thought is that such a vote of confidence from the U.S. government will appease depositors' concerns, we won't have any more bank runs, banks will feel more comfortable lending again, and we can start to heal the wounds.

Like we've discussed with the short sale ban, however, we need to be aware of the law of unintended consequences.  Banning short sales has been proven historically to reduce liquidity and increase volatility, all while not preventing major stock market declines.  It's safe to say we're seeing that play out in real-time.

Ireland recently moved to do increase deposit insurance, in a program similar to what the U.S. is considering.  One of the consequences is that the price of insuring against the default of Irish sovereign bonds jumped more than 60%.

The chart below shows similar prices against default risk for the G10 countries.  The higher the lines in the chart, the more traders are betting on a default:

The prices are still very low when comparing them to corporate bonds, but some of them, such as for the U.S., have doubled in less than a month.  If the bailout plan passes, they will likely rise further.

So, why should we care?

Well, if traders are betting on the increased risk of default on bonds, then they will demand to be compensated for taking the risk of buying them.  That means higher yields.  We could very well see Treasury Bonds decline in value, with an accompanying spike in bond yields.  If that happens, it increases the cost of borrowing, which is not something which will help us out of this economic malaise.

That's a pretty simplistic analysis - there are a lot of moving parts to this - but it's at least something to watch in the coming days.  A major increase in bond yields would likely hamper a stock rally.

Getting back to the core purpose of this site, sentiment analysis, the big question is whether we're seeing - or have already seen - enough pessimism among investors in order to sustain another major bear-market rally.

One of the unique aspects of this decline, besides the fact that it has been more centered on the credit market than the equity market, has been the sudden and breathtaking nature of the declines.  Prices have recovered over a couple of sessions, then lose 3% or more in one fell swoop.  That kind of price action makes it a bit more difficult to get pessimistic extremes in our guides.

Still, we are seeing plenty of stretched readings.  The latest Investor's Intelligence survey showed the Bull Ratio drop from nearly 48% last week to under 42% this week.  That's still higher than the depths we saw in July, when the Bull Ratio dropped to about 36%, but it's still in the bottom 10% of all readings since 1969.

A few days ago we looked at how Rydex mutual fund traders were stuffing money into the safety of their money market fund, and that's still the case.  They've also been shifting money into the inverse funds, with total assets in the "bull" funds almost exactly equal to those of the "bear" funds, historically a decent contrary signal.

Implied volatility has spiked to an historic degree, but I'm not going to point out of too-often-discussed VIX readings, which closed at a new high on Monday.  I'm more interested in the historical volatility we've seen.  The price moves in the S&P 500 over the past week, when extrapolated forward, would suggest that the index will move more than 90% over the next year.  The only other time in 58 years it has exceeded this level was in the aftermath of the '87 crash (when it reached over 200%).

There are some missing pieces as far as pessimistic extremes go.  For example, we have not seen corporate insiders stepping up to buy heavily, which is troubling.

And we have not seen options traders seem too concerned about the recent troubles, with the smallest of traders spending less than 20% of their volume on protective put purchases last week.

That possibly changed this week, as the data doesn't include Monday's crash, but based on the daily put/call figures we've seen this week, it's unlikely small traders have spent more than 25% of their volume on buying puts, which would equal some prior extremes.

We've discussed in the past how big extremes in put/call ratios typically do not mark an exact price low in stocks, so it's not all that unusual to see less of an extreme in indicators like the Equity-only Put/Call Ratio now than we saw a couple of weeks ago...but still I'd prefer to see more defensive posturing from the smallest of traders.

On Monday, we went over some of the historically extreme readings that triggered.  When we've seen that kind of selling pressure in the past, the only precedents that apply are past all-out market crashes.  The behavior of market participants after those other precedents were fairly consistent - we almost always saw a big bounce in the very short-term, then some backing-and-filling as the low was tested, then a more lasting rally.

Yesterday afternoon, I pointed out that waiting for a couple of days after other crashes, and holding for a few days, resulted in a losing trade every time, highlighting the tendency to see selling pressure after the initial knee-jerk bounce.  I suspect we're in for the same here, but after a week or so of volatile trading, we should be at the best risk / reward opportunity for longs that we will see in the fourth quarter.