Shooting The Last Arrow

10/08/08 8:30 AM EST

Good Wednesday morning...We begin the day with what is indicated, at the moment, to be a large gap up open in the pre-market futures.

Traders have been demanding a coordinated rate cut across the globe, and they got it this morning.  Whether it matters or not remains to be seen - they've gotten pretty much everything else they've demanded over the past week, and yet we closed at a new low yesterday.  It is at least helping foreign markets, with the UK's FTSE index up nearly 10% from its intraday lows.  If this doesn't work, one has to wonder what "surprise" move the government can take next.

A few weeks ago, we started looking at a "crystal ball", multi-step kind of forecast that I almost always shy away from.  It's hard enough trying to judge risk/reward scenarios immediately ahead, much less those that contain a bunch of "if" statements.

Regardless, the studies we looked at suggested that through (approximately) the end of September, we should see extremely volatile conditions with a downward bias.  That should lead to a wicked short-term rebound, a testing of the momentum low, then the best long-side opportunity we'd see during the entire fourth quarter.

Up until this week, things were looking pretty good.  Last Monday's decline was more severe than anticipated, but it was the kind of watershed event that could objectively only be compared to 9 other crashes in the past 100 years.  And taking a look at those other crashes, a consistent scenario played out time and again - a vicious one- to three-day rebound, which quickly failed and led to a re-test of the panic low.  That "re-test" usually meant at least a touch of the prior low, and in many cases a violation.  In all cases, however, a more intermediate-term bottom was formed within 5 to 10 days of the crash.

We're right in the sweet spot of that time frame, so it seems like everything's still on track.  This Monday's mini-crash took us well below what I thought would be the worst-case levels in the major indices, but we got a late-day rebound that took us right back into the zone (1050 - 1075), and big reversals from extreme price losses tend to lead to upside follow-through.  So even by Monday's close, it looked alright...tattered, but still hanging on.

Yesterday was a different matter.  That kind of selling pressure should not have occurred.

Sure, we generated all kinds of extremes again, but those only work to a point, and we seemed to have passed that point.  We've already witnessed selling pressure on an historic scale, one which has led to short-term snapbacks virtually every time they've occurred, even during the worst bear markets in history.

The constant pressure has certainly seeped into many of the indicators we follow on the site.  Just this morning, the latest Investor's Intelligence survey showed that barely 25% of newsletter writers expected stocks to rise going forward, down from nearly 40% a month ago and more than 60% last October.  It's the lowest number of bulls since 1994, and is in the bottom 2% of all readings since 1969.  More than 60% of our indicators are somewhere within "excessive pessimism" territory, the most in a decade.

Reports of people throwing in the towel are widespread.  The market strategist for Citigroup just went from being the most bullish analyst to the most bearish, recalling shades of March 17th (the day of the low) when Goldman strategist Abby Cohen decided to stop making (almost always bullish) forecasts.

Never before in 100 years has the Dow lost 1% or more for five straight sessions, totaling a loss of more than 15%.  Disregarding the total loss, it has gone down 1% or more five straight days three times (02/24/1898, 12/13/20, 04/29/31).  It's tough to read anything into an event that last happened 77 years ago, but over the next three days the index was up each time, averaging +2.1%.  There was zero drawdown, meaning that the close of the day with the fifth 1% loss wasn't violated over the next few sessions.

But we looked at a similar stat yesterday, regarding four straight 1% days.  In that rare history, we saw the same conclusion - this kind of persistent selling pressure leads to bounces.

I'd been slowly building some intermediate-term positions into the re-test of last Monday's panic low, and added a last bit into the gap down into 1075ish.  I'm now about 25% invested with a time frame of one- to three-months, and am not at all happy about sitting on my largest drawdown of the year.  Even at "just" a couple of percent, I don't really care that the indices are down so much more - I strive for absolute returns no matter the environment.

At this point, again with an intermediate-term time frame, I don't think it makes sense to sell (I remain convinced that we will witness the low of the fourth quarter this week), but I am fully aware that there will quite possibly be further short-term losses.  Even when we do get the multi-month positive reaction, I would be lucky to get back to breakeven on those early purchases.  It's more likely that the steps I take in the next several sessions will determine a big part of how the fourth quarter will turn out.  Still sitting with 75% cash, there's wiggle room, but I don't want to keep buying into a market that is showing no signs of responding.

From here, in order to add to losing positions (something I'm always loathe to do), I will require a monstrous rebound that then settles back down, something akin to what we witnessed last week.  The only other possibility, and this one is more remote, would be another all-out crash...and by that, I'm talking a 10% - 15% one-day loss.  It seems unfathomable, but then again so did typing 996.23 for my closing S&P 500 figures yesterday.

We're getting a fairly large gap up opening this morning, so as usual with a large gap up, I will be watching the high set during the first hour of trading.  If we can set a higher intraday high after the first hour, then the probability is good that we will continue to see buying pressure throughout the day, and I suspect we'd have a decent chance at seeing a trend day higher.  If we sell off from the open, then I don't know how bad it will get before we finally see a level attractive enough for size buyers.