Wringing Out The Late Speculators

11/05/08 4:15 PM EST

As of: SPX 1045 HELP  ARCHIVE

On Monday and Tuesday, we touched on several short-term indicators and patterns that suggested any further push higher probably would not be sustained.  Because of the quick move off the lows, traders who are normally wrong at the extremes had started buying into the idea of a rally.

Given all of the more intermediate-term studies we've discussed that call for higher prices in the coming month(s) (including another one this morning that looked at the quick flip-flop in breadth extremes), the focus will now shift back to finding a good risk/reward opportunity to remove hedges and establish or increase long-side exposure.

Our intraday indicators are making quick work of cycling back down towards oversold, with most of them now below their lower trading bands.  The Price Oscillator in particular is down to a level not seen since the bottom on October 10th.  The pace of selling hasn't been enough to push one of the other reliable measures, the Cumulative TICK, into oversold territory yet so that is a missing piece here.

Since the inception of the S&P 500 tracking fund, SPY, there have been 31 occurrences where it rose at least +0.5% to at least a new two-week high one day, then fell enough to close below the prior day's close the next - the same pattern we've seen over the past two days.  Short-term, we tended to see additional weakness.  Over the next two days, the S&P managed to gain only 32% of the time, and sported an average return of -0.5%.

There were two that are fairly close comparisons to our current situation.  One of those that turned out to be a winner was October 16, 2002 as the market was emerging from the bottom formed four days earlier.  The next day, the S&P jumped 2% and rose in a choppy manner for the next month and a half.  Another of the winners was March 24, 2003, coming after the bottom eight days earlier.  Then, the S&P jumped nearly 1% the next day but then fell over the next four before embarking on the next leg of the bull market.

Continuing its long list of extremes, down volume on the NYSE was 16 times greater than up volume today, one of the larger bouts of selling activity we've seen over the past couple of months.  It was this extreme or more so on six other days during September and October, with the S&P bouncing the following day four times (before rolling over to a new low each time).

All of these don't help a whole lot at mapping out what we should probably expect in the short-term, as they conflict somewhat as to time frame, except perhaps that it was rare to see immediate and sustained strength right away.  Personally, I'm relying more on the intraday indicators and would prefer to see some true extremes there before becoming too optimistic that the pullback has likely run its course.

One day isn't a lot of time to expect all the new speculation to get wrung out, so ideally we'll drift lower for another one or two sessions, with the S&P holding above 920 - 940ish.  None of this is set in stone - we've seen so many unprecedented developments over the past month that nothing can be ruled out, but for the moment my game plan is to look at removing hedges on my long positions on a further dip over the next session(s).  That would still only leave me 10% invested, and I'm not sure yet if I would be adding to that amount.

Quick Flip In Breadth Another Long-term Positive

11/05/08 8:55 AM EST

Good Wednesday morning...We begin the day with some selling pressure in the pre-market futures, though they are well off their lows of the early morning hours.  With the election now passed, attention will turn quickly to earnings and economics, both of which remain sore spots.

The past month has witnessed a number of historic developments in politics, in business, in economics and in the auction markets.  We spent a good part of mid-October going over many of the last, and we continue to register more.

Part of the overwhelming sense of desperation last month was caused by the sheer depth of the selling pressure.  On several days last month, so many stocks were declining at the same time that we'd have to go back more than 30 years to find anything comparable.  But we saw so many of those days last month, that nobody trading the markets now has ever seen anything like it.

Now we're finally getting a recovery from that morass, and the buying pressure has been impressive.  Just as traders were pressing almost everything down last month, they've been pushing nearly everything up over the past week.

That's most clearly reflected in the Up Issues Ratio.  This is a short-term view of market breadth - how many stocks rose versus dropped over the past week.  If the 5-day Up Issues Ratio shows a reading of 60%, then that means that of all the stocks moving up or down, 6 out of 10 moved up on an average day over the past week.

The current reading is a remarkable 71%, the highest in more than 15 years.  That is grossly overbought, and typically stocks tend to pull back from readings so extreme.  But it means something else, too...markets that go from severely oversold to severely overbought are usually ones that keep going up in the intermediate-term.

To test that, let's go back to 1940 and look for any time when the 5-day Ratio goes from a deeply oversold level (less than 35%) to an exceptionally overbought one (greater than 70%) within two weeks.

The table above shows that over the next week, the S&P 500 did fairly well, rising nearly three times out of every four, but it was choppy trading during the first two weeks.  Only twice did the index manage to shoot higher and not really look back (1962 and 1982).

Confirming the other studies we've looked at lately, this burst of buying pressure preceded very good gains in the intermediate- to long-term.  The three-month returns weren't spectacular, but by six months later the S&P was up every time but once, averaging a robust +11.1%.

On Monday and Tuesday, we looked at a few different overbought types of indicators, showing that traders have quickly become comfortable with the idea of a rally.  In the past when we've seen these kinds of readings, the market has struggled to sustain gains in the short-term.

So far the indices have rolled right over any sense of short-term overbought, which is precisely the behavior we should want to see for intermediate-term long positions.  The market is unfolding in classic fashion for a one- to three-month rally attempt, and I see no reason to change that expectation now.

The short-term is a much more difficult call.  There is ample evidence suggesting that we should pull back, which is what everyone else is seeing and looking for the same thing.  I hate to try to outguess the guessers, so I'm not going to conclude that we won't get a pullback just because it seems like so many others are too.  I prefer to stick with hard stats instead of anecdotal "evidence".

It would not be unprecedented for a market that had become so severely oversold to simply continue higher without more than a one-day pullback like we saw last week.  But when the recovery gets to between six and eight days, we usually do see a multi-day pullback, even if it may not be at all deep...just two to five sessions of choppy or modestly declining prices.  We're pushing the upper boundary of that time-wise, and combined with the overbought readings we've discussed and the potential technical resistance just overhead, I continue to think the S&P won't see any sustained gains above 1025ish just yet.

With the risk of a slower, steady climb higher seemingly about equal to that of an imminent pullback, it doesn't seem to make much sense to push on either side of multi-day positions.  In response, I've put on short-term hedges for already-modest intermediate-term longs, and will look to remove those once these stretched conditions abate.  If we just continue to push higher without more than a one-day rest, that's going to make for an uncomfortable decision about when to remove the hedges - the last thing I want to do is increase long exposure into an overbought bear market, even with expectations of gains over the coming month(s).