A Good Sign Of Buying Interest

10/29/08 8:50 AM EST

Good Wednesday morning...We begin the day with what looks to be a mixed open at the moment, but as usual lately the pre-market futures have been very volatile.  Since yesterday's close, the S&P has lost as many as 25 points, and rallied as much as 40 from those lows.

A day like yesterday is sure to trigger some extremes, and one of the more notable ones was volume.  Volume flowing into stocks that were up on the day trumped down volume by a 19-to-1 ratio, the most skewed buying pressure we've seen since last August.

The actual number of advancing stocks vs. declining stocks wasn't quite as impressive.  While up volume accounted for 95% of total volume, stocks that rose on the day accounted for "only" 79% of all stocks.

When we get a difference like that, it makes for extreme readings in the Arms Index, also known as the TRIN.  The Arms Index is the advance/decline ratio divided by the up volume / down volume ratio.  Because the denominator (up/down volume) was so much larger than the numerator (up/down stocks) yesterday, the Arms Index closed at an exceptionally low value of 0.20.

The interesting thing about this indicator is that low levels, especially when sustained over a period of several days, tend to mark overbought conditions.  However, extremely low one-day readings tend to indicate the exact opposite.

We posted a new Signpost study today which looks at all Arms Index readings of 0.20 or below since 1940, with the performance of the DJIA going forward.  Three months after similarly low readings, the Dow was up 18 out of 21 times by a little over 3%.

What's even more unusual about yesterday's reading is that it occurred so soon after a series of very high readings, which indicate oversold conditions in the broader market.  The 21-day moving average of the Arms Index that we post to the site was greater than 1.5 yesterday, high enough to be considered historically extreme.

There were only four other times in the past 68 years when we saw an Arms Index reading under 0.20 when the 21-day average of the ratio was 1.5 or higher.  They were all in the 1940's (06/11/40, 08/04/43, 09/11/46 and 10/15/46), and all led to generally rising prices over the next one to three months (though it was exceptionally choppy trading).

Yesterday we looked at a couple of oversold types of indicators, one related to breadth the other to consumer confidence.  Both had reached historic extremes.  We also looked at the only other two times in the past 110 years when the Dow rallied 7% or more from a 52-week low within one month of each other.  Both led to good intermediate-term rallies.

Over the past several weeks, we've discussed a lot of other indications of excessive pessimism and typical reactions following market crashes.  There is no doubt we've seen a crash, and so far the market has acted somewhat in line with historical precedent.  We've seen a little more weakness, at least more quickly, than usual, but the lows from the October 10th panic have so far held for the S&P 500.

What we haven't seen is committed buying interest.  That's still up for grabs - we need to see more than another one-day rally - but the fact that we've seen two of these huge up days is rare and historically meaningful.  Whether it's due to portfolio rebalancing, month-end window dressing, whatever...I don't care about guessing on the reasons behind the buying, so long as helps to change sentiment.

From this point, ideally what we would see is one to three days of upside follow-through, followed by a one- to three-day pullback that helps to relieve whatever short-term overbought conditions that would probably be generated.  Most importantly, I want to see the S&P 500 hold above 890 - that's the approximate highs of the prior two sessions, and also the 50% retracement level of the most recent rally.  If we are truly seeing a change in character, then we should not dip below that level.  If we dropped all the way below 875ish, then I suspect we would then be in store for new lows.

The focus today will obviously be the FOMC decision at 2:15pm EST.  Currently the Fed Funds futures market is pricing in a 52% chance of a cut to 1.0%, and a 48% chance of a new all-time low of 0.75%.  There has been some concern that the futures market is distorting the true sentiment of traders due to recent government interventions, so it's difficult to say what exactly traders are expecting to see today.  The prevailing sentiment appears to be at least a 50bps cut, and anything less than that should usher in an initial wave of selling pressure.  Other than that, we'll just have to see how it goes.