Another One For The Books

10/24/08 4:30 PM EST

As of: SPX 1045 HELP  ARCHIVE

Severe market sell-offs are relatively predictable in the sense that sharply decreasing prices tends to increase the amount of uncertainty, and in some cases induce outright panic.

A couple of weeks ago, we saw that in action as a week straight of plunging prices moved many of our indicators to extreme levels.  Since that time, we've witnessed a very volatile back-and-forth environment which isn't all that unusual when compared to past crashes.

But recent activity has begun to wear on traders, and as a result we're seeing some readings we wouldn't normally see.  Earlier we looked at small trader option trading and the AAII sentiment survey, as well as the latest mutual fund flows from AMG Data (which showed an inflow to stock mutual funds after a couple of weeks of massive outflows).

One possible explanation is that sellers are so exhausted that they've sold most of what they can or will sell.  That would normally be bullish for stocks, but we don't just need a lack of motivated sellers, we need committed buyers.

Another oddity comes from the Commitments of Traders report.  I pretty much ignore the positions in the major equity index futures anymore, as the behavior of traders has changed over the past couple of years and I don't find it nearly as effective as it used to be.  That's only for equities, though - I still find it useful for commodities and currencies.

One of the contracts I don't discuss much is the relatively new VIX contract.  This is the measure of traders' expectations for future volatility, a decent proxy for how much uncertainty is being priced into the market.

The latest data showed that commercial hedgers have moved to a new record net long position in the VIX.  That group of very large traders is normally considered "smart money", so if they're long the VIX, then usually we would suspect that they are looking for even higher volatility and thus lower stock prices.

As we can see from the chart above, though, the last time they became very net long was earlier this year, right before volatility dropped.  That's the opposite of what we would normally expect.

Ostensibly, the dumbest money among the three sets should be small speculators, those who don't take positions large enough to be reported.  In most futures contracts, they take extreme positions at precisely the wrong time, but in the VIX they have in fact been the smartest money of all.

These folks went majorly long volatility in May and August, right before we saw the VIX spike higher (and stock prices fall).  Now, they're holding short positions in anticipation of volatility returning to a more normal level over the coming months.

That's counter to how we usually view the CoT data, but I'd consider it a (very) minor positive for the market at this point.  And we need all the positives we can get, as the multitude of extremes that triggered a couple of weeks ago have not worked their usual magic by leading to generally rising prices.  Even in the context of an ongoing bear market, we should still be seeing a rebound over several months from the October 10th low.

That low is still in play.  We came close during the depths of pre-market trading, in fact the S&P 500 tracking fund, SPY, did violate that low from the 10th.  It was hard to gauge just how accurate that was, though, due to index futures being locked limit-down in early trading for one of the very few times in history.

Many of us were looking, some would say hoping, for a major washout during the morning hours, then a recovery into the close.  That would be more classic bottoming action, but once again we have to wonder just how likely it is if so many are looking for that very thing.  At times like this, it seems as though "everyone" is a contrarian, "everyone" is looking for the same patterns, and "everyone" is trying to outguess those trying to outguess their own behavior.  It's a circular trap that can give a guy a pounding headache.

Personally, I prefer to keep things as simple and straightforward as possible.  And in that regard, I continue to believe that based on everything we discussed on October 9th and October 10th, we formed an intermediate-term low at that point and are in the process of fleshing that out.  If we can't hold those lows, then we'll be witnessing something we haven't really ever seen in 110 years, and all bets are off as to where we may finally bottom.  Many are looking for a test of the 2002 lows around 775-800 on the S&P, and that seems about as reasonable as any other projection.  At that point, we would be in completely uncharted waters so one guess is as good as another.

We'll see what the weekend and early next week brings.  The most oft-cited wish for traders right now is a bad opening on Monday that triggers the kind of negativity we didn't get today - the traditional ugly Monday morning in October - then a rebound later in the day.  Either way, it'll be another harrowing week.

Have a safe and restful weekend and we'll see you next week.

The Oddities Continue

10/24/08 12:40 PM EST

As of: SPX 1045 HELP  ARCHIVE

Frustrating almost everyone except the most faithful of "gap and run" bulls, stocks have been on a fairly steady march higher since the opening bell.

This is one of the oddest markets I've ever seen, not just because of the volatility but also the divergent readings we're seeing.  Earlier this week we went over a couple of them (small trader option trading and the AAII sentiment survey).

Another came yesterday in the form of the latest mutual fund flows from AMG Data, which showed an inflow to stock mutual funds after a couple of weeks of massive outflows.

One possible (and plausible) explanation is that sellers are just plain exhausted.  They've sold most of what they can/will sell, so what's the point in becoming even more bearish?  Sounds as good a reason as any for some of these readings.

The uptrend from the open has pushed a few of our shortest-term guides for the Nasdaq 100 towards overbought territory of all things, with the Cumulative TICK and Price Oscillator flirting with their upper trading bands.  The STEM.MR Model for that index is still well within neutral territory, but we're already seeing the indices pull back from the morning highs as I type.

Another unusual situation was raised by a subscriber - we gapped down huge in the indices, but the lowest reading in the NYSE TICK today is only -950.  Normally if we saw price losses of 5% or more, there would be several readings of -1200 or worse.

Going back over the past decade, I could find only four other days where the S&P gapped down 3% or more, and by noon the lowest TICK reading was above -1000.  Those were 09/17/01, 09/21/01, 01/22/08 and 09/15/08.  From noon going into the close, the S&P lost ground 3 of the 4 times, averaging -0.8%, and we also saw a gap down the following morning 3 of the 4 times.  Not sure we can reach much into four instances, but I thought it was interesting.

The stat above and the kinda-sorta overbought NDX readings are modestly troubling, but I'm encouraged by the seemingly exhausted selling pressure.  I know many traders were disappointed that we didn't get even bigger losses to start the day, or an initial dive down below the October 10th lows before a reversal.  Perhaps that's in store for Monday when many are looking for the classic October wipeout and reversal.  For my part, I'm still not doing any trading until I can find a better setup than what we're seeing here.

What A Way To Start The Day

10/24/08 7:20 AM EST

Good Friday morning...We begin the day with what could only be called a crash right across the board.  Foreign markets are down 7% - 10%, non-US Dollar and non-Yen currencies are tumbling, and Treasury Bond yields just traded at an all-time low.  More than $10 trillion in worldwide market capitalization has been erased...just in October.

Checking some major overseas indices this morning, between the Dow Jones Euro 50 index, the UK's FTSE, Germany's DAX, France's CAC 40, Switzerland's SMI and Japan's Nikkei 225, out of 464 stocks only 3 are up on the day.  And those were all in Japan.

The selling has caused trading to halt in S&P, NDX and Dow Jones futures contracts.  The Chicago Merc instituted price limits to the index futures in 1988 in response to the '87 crash.  They changed the amount of the limits several times, and finally moved to the current percentage-based system in 1998.  There is a smaller limit allowed during non-regular trading hours, which is why the futures were halted this morning.  The limit will lift at 9:30am EST, at which point the next limit (-10%) would come into play.

The only other time this has occurred was January 22nd when the futures were locked temporarily after falling more than 5% before the open.  At the time, we went over what prior pre-market crashes looked like (there were only two - Black Monday and 9/11), and by that morning it looked like a short-term buying opportunity.  This time, I'm not nearly as sure.

I have been operating under the expectation that October 10th would mark an intermediate-term low based on everything we discussed up to that point.  The reaction on that day and the subsequent sessions were perfectly in line with past lows, and it looked like we should be on our way to a decent fourth quarter.  While some short-term back-and-forth activity after the initial rally was to be expected, the drop over the next couple of days was very severe and raised a few questions.

Even so, we held up fairly well until this week.  My intention has been to buy into short-term oversold conditions, but as I noted yesterday afternoon, our short-term guides have still not cycled into extreme territory and the fact that the Nasdaq 100 made a new low was not a good thing.  It managed to shoot higher into the close, giving some hope of a "false" breakdown, but this morning's activity obviously negates that.

These artificial limits make price discovery very difficult, so it's hard to say what might happen at the open, especially if the FOMC announces an emergency rate cut or other measure.  Barring some major government announcement, a lot will ride on what happens to overseas markets, most of which are down about 8%.  If the S&P followed suit, that would take us down to around 835 in the cash index - precisely the low from October 10th.

It seems awfully cute to think that the index would hit that exact level and turn on a dime, ending this debacle.  It might be good for a bounce for hyper-aggressive traders, but it seems just too pat to expect that level to be touched exactly and end the selling pressure.  I would prefer that to be the case, but I'm not very optimistic about it.  If we're going to see a major reversal, a more likely route would be something similar to the NDX from yesterday - an undercut of the low that washes out what are sure to be many stop loss orders, then a reversal back above.

We have witnessed a very large number of "never seen before" events over the past couple of weeks, so if we cannot hold the lows from October 10th, then all bets are off.  Many are looking for a test of the 2002 lows around 775-800 on the S&P, and that seems about as reasonable as any other projection.  From my perspective, we would be in completely uncharted waters so one guess is as good as another.