In The Aftermath Of Extremes

12/04/08 9:00 AM EST

Good Thursday morning...we begin the day with some weakness in the pre-market futures as a continued stream of poor corporate earnings dampen early enthusiasm.  Non-Yen currencies continue to retreat, commodities are again pulling back, and overseas markets have reversed earlier gains.

Credit-related issues continue to plague the market, and they haven't improved much despite the recent stock rally.  As the Financial Times reported this morning, credit spreads are still widening to historic highs, not confirming the improved outlook that stocks are seemingly suggesting.  Even a quick look at a fund like HYG, which is slogging around near its November lows, will show that traders haven't completely bought into the government intervention's ability to brighten the corporate outlook.

Despite the crazy volatility and seemingly random moves on a day-to-day basis, we can take a little bit of comfort in the fact that the equity market as a whole continues to respond to short-term extremes when they occur.

Defining "extreme" is, of course, the tricky part.  The indicators we update intraday have done a pretty good job of it, but this morning I want to touch on a handful of others that we take a look at occasionally:

We can see from the chart that when all the indicators hit one extreme or another (not necessarily on the same day but within a few days of each other), the market has responded with a counter-move within a day each time since September.

The latest one was the overbought readings from last week, preceding Monday's huge decline.  Since then, we've seen two days of almost exactly the same intraday pattern, and the steady recovery from Monday's low hasn't given the indicators any time to cycle back down towards another oversold extreme.

During bear markets, when we see that kind of a pattern, the recovery has a greater tendency to fail than not, and at some point we get those oversold extremes before another sustained rally attempt.

The one consistent exception is when we're emerging from severely oversold intermediate-term conditions, and buying interest is so strong that we never get a pullback that's long enough to generate even short-term oversold conditions.

The pattern that we've seen since the November low is fairly consistent with that idea - we hit historically oversold conditions on both a short- and intermediate-term time frame on November 20th/21st and the following week generated many extreme overbought conditions on a short-term time frame.  Now we're chopping around in the volatile wake of that flip-flop in extremes.

This raises the chances that we're once again on the cusp of a potential multi-month rebound.  It looked good in late October, too, but that setup failed heading into November, causing all kinds of consternation about a market that was not responding well to historic precedent.

That's still a concern, and is the main reason why I want to see some additional recovery here before becoming too wed to the idea of that multi-month bear-market rally again.  I want to see credit spreads improve, and a move over 900ish on the S&P will create a series of higher highs and higher lows, the main quality I'm looking for in a nascent recovery.  From there, I would look to again establish some intermediate-term long positions.

Because the market is still responding to extremes, I would also look to establish some longs on another drop that generates oversold conditions.  Based on where we are right now, that possibility is a ways away.

I mentioned last week that if we approached the 900 area on the S&P, I would be more inclined to sell short.  Monday was an obvious rejection of that level, and another approach later this week that generates some overbought readings could set up another short sale.  I'm a little less inclined to trade that way because of the positives we discussed yesterday, but it remains a possibility if we get a couple of smaller-range days towards (and below) that general area.