Getting Ready For The Fireworks

10/02/08 2:50 PM EST

As of: SPX 1270 HELP  ARCHIVE

For a time, when we saw the price of Crude Oil get smacked like it is today, we'd see the broader equity market doing just the opposite.  Inter-market correlations are a fickle beast, however, and it's clear that traders' attitudes have changed - declining Oil no longer signals a positive reduction in inflation expectations, rather it's a sign of a slowing worldwide economy and possibly even deflation.

This is most curious when looking at the move in the Dow Jones Transportation Index today, which is down more than 8% as I write.  The Transport index usually has a tighter relationship with Oil than other indices, as Oil by-products are a major cost to transportation companies.

Going back to 1983, I can't find any other time when Oil was down more than 4%, and the Transports were also down nearly as much as they are today.  The worst I could find was a 4.2% loss almost exactly 10 years ago.

Loosening the parameters a bit, there were five other times the Transports lost 3% or more on a day that Oil slipped 4% or more (10/1/98, 10/8/98, 1/21/00, 3/14/01 and 7/22/02).  For what it's worth, the performance in the sector was mixed in the short-term, but after a month it was higher 4 of the 5 times by an average of +11.9% (the sole loser, in 2000, was -12%).

After Monday's collapse, we discussed a multitude of different studies which basically suggested that Monday qualified as an all-out crash.  The only comparable periods to the price action and breadth statistics we saw on Monday were instances that almost anyone would identify as a plunge.

The usefulness of that is that it helps to tell us what we may expect going forward, and as we went over in a Data Brief, we should have expected a wicked one- to three-day bounce off of Monday's low, then another big decline that challenged those panic conditions.  It wouldn't be at all unusual to see a modest undercut of the low, but it should be quickly regained (within a couple of trading sessions).

The market has played out that scenario well so far, though the bounce wasn't quite as large, or quite as long-lasting, as we've typically seen.  And today's re-test is coming very quickly - it normally happens within a week, but this is a little soon.  I'm probably just splitting hairs.

The bottom line is that by several objective definitions, we crashed on Monday.  The trading activity since then has been almost classic in its comparisons to past post-crashes.  Which means that today and the next several sessions should be the formation of an intermediate-term low that lasts into the end of the year.  How will I know if I'm wrong?  Unfortunately that determination won't come unless we keep skidding for several days, and probably another 5% - 10% lower, which is why I'm keeping position sizes very small.

The short-term can still be hair-raising, and it may take another market-induced prompt to get the government to do whatever it is going to do to help dampen this crisis.  Traders are now absolutely demanding an emergency rate cut, pricing in a 96% chance of a 50bps ease in the Federal Funds rate, up from the 72% chance we mentioned this morning.

If we see a bad close today (and the market is so far showing all the classic signs of a trend day down that usually closes at or near its lows), and we get a bad reaction to the jobs report tomorrow morning, then I would be shocked if the FOMC does not come in with a surprise rate cut.  Be on your toes here, both ways, as I think we're in for more fireworks over the next several days.

Bad September Leads To Cash Crush

10/02/08 9:15 AM EST

Good Thursday morning...We begin the day with some selling pressure in the pre-market futures.  They ticked down and have stayed down ever since the Senate passed the rescue bill (not before stuffing it with more pork than an Iowa hog farm, of course).

The bill still has to be passed in the House, and there are some reservations about its likely success in doing so.  Traders are also concentrating on the continuing sag in nearly every economic release, and the potential problems with bellwether companies like GE (after just telling investors everything is OK, why did they give such a sweet deal to Buffett, and why do they have to price their stock offering 9% below the recent closing price?).

One of the charts we post to the site is the asset allocation among members of the American Association of Individual Investors (AAII).  That service is better known for its weekly sentiment survey, but it also asks its members on a monthly basis how they have their portfolio allocated among stocks, bonds and cash.

The latest results were just released, and it showed another uptick in their current bias against the stock market.  For only the third time in 20 years, these individual investors have allocated more than 35% of their entire portfolio to cash.  The other two times were November 1990 and November 2002.

Politicians debating the merits of the financial rescue package have tried to frame their argument as the interests of Wall Street against those of Main Street.  I'm not going to get sucked into that vortex, but I would point out that just as Main Street is negative on stocks, Wall Street isn't far behind.

As you can see from the chart to the right, the recommended allocation to stocks among Wall Street strategists isn't much higher than that of the individual investors - and in fact, it's the lowest since 1998.

Individual investors (AAII members) have allocated 51% of their portfolio to the stock market, the lowest since the end of the last bear market.  Wall Street strategists are recommending 58%, not much above Mom and Pop.  Given Wall Street's propensity to almost always recommend buying stuff, that's pretty remarkable.

It's no wonder sentiment has turned so sour after one of the worst months on record.  One potential positive is seasonality - historically the market has bounced back from bad Septembers.

The chart below shows the cumulative return over the next three months any time the S&P 500 has dropped to a new 12-month low during September.

All five instances led to at least a 6% gain by the end of the quarter.  Only 3 of the 15 total months showed a negative return.  The risk / reward was very skewed - on average, the index lost a maximum of -2.5% at its worst point during the next three months, while enjoying an average maximum gain of +12.4%.

We're still not seeing a lot of improvement in the credit markets.  There is still a demand for the shortest-term Treasurys, and Libor has not eased much over the past few days (I use the overnight rate, which has eased a bit, while most others use the 3-month rate, which continues to inch higher).  Now that CNBC is running a "bug" on its screen that updates the TED Spread, its usefulness as an indicator has probably passed (seriously, is there any better contrary indicator than the CNBC ticker?).  Other credit-market signs continue to remain mixed, with no clear improvement yet.

Since this appears to be primarily a credit-market event, this is not a good sign and it's something everyone rightfully continues to watch in order to have some confidence in the idea that Monday was the same kind of exhaustive move it has historically been.  Readings like we saw on Monday have almost always led to positive intermediate-term returns after some short-term volatility.

In the short-term, there is some question about whether the initial knee-jerk reaction off the low is sustainable.  On Tuesday one of the ideas we discussed was that after every other market crash, stocks fell back after the first rabid rise off the panic low.  Also, our shortest-term guides are relatively overbought, and stocks have struggled after prior such readings.

We're still obviously in a news-driven tape, and that won't change any time soon.  The rumor now is that the FOMC will step in with a rate cut, something upon which traders are increasingly relying.  The Fed Funds futures market is now pricing in a 72% probability of a 50bps cut in the Fed's target interest rate by the end of the month, which is up from only a 34% probability just yesterday, and 0% a week ago.  Whether it will actually help the market in the long-term is doubtful, but such a "surprise" cut would almost certainly give us a shot in the arm in the very short-term.

So trading this mess remains treacherous, and we have to be on the lookout for wild swings both ways.  I remain confident that Monday's purge should mark the end of the bulk of the selling, though we likely have week(s) of testing that low.  A slight undercut of it would not be unusual, as long as we regained it within a day or so.  Such a move should set up the best buying opportunity we'll see in the fourth quarter.