Buying Thrust Is Another Good Sign

12/09/08 9:15 AM EST

Good Tuesday morning...we begin the day with a bit of selling pressure in the pre-market futures, though they have swung between minor gains and losses all morning.  Other asset classes are mostly reversing their moves over the past two days, and overseas markets are showing modest upside.

Yesterday we took a look at the Up Issues Ratio, which had reached a level we could consider excessively overbought.  Historically so, even.

While that has tended to lead to mixed performance in the short-term, with the market not usually making much headway (or falling apart, either), on a more intermediate-term basis there was some good reason to consider it a positive sign.  The last 13 times it has occurred, the market rallied over the next one to three months every time.

Another anomaly occurred yesterday, with a slightly different breadth measurement.  This time we're looking at the Up Volume Ratio.  The ratio computes the amount of volume that is flowing into stocks that were up on the day, expressed as a percentage of total volume.  So an Up Volume Ratio of 60% would mean that 60% of that day's volume was concentrated in stocks that closed higher than the previous day.

Over the past two weeks, we have seen consistently heavy buying pressure.  To such a degree, in fact, that it has pushed the 10-day average of the Up Volume Ratio to just under 70%, the first time in more than 20 years we've seen such an extreme.

Even more notable, however, is that over the past 65 years, the Up Volume Ratio has shown a negative secular trend.  Over time, less and less total volume has been allocated to "up" stocks, which seems odd considering that the market has risen several-fold over the decades.  In the 1940's and 1950's, it was common to see an Up Issues Ratio greater than 60%.  Since the early 1990's, it has become much less frequent.

The reason I bring this up is that it highlights just how unusual the current reading is.  So instead of looking at an absolute level and trying to compare it to historical readings, we should use some kind of relative measurement that looks at today's reading in comparison to more recent averages.

A good way to do that is to use Bollinger Bands.  The chart below shows the two-week Up Volume Ratio in terms of how many standard deviations it is from its one-year average.  As we can see from the chart, what we're seeing now is 3 standard deviations away from "normal".

It's safe to say that's a pretty extreme event, and it's even more so when we consider that what we're looking at is not a one-day reading, but an average over the past 10 trading days.  So we have to be seeing a sustained level of huge buying pressure in order to get the 10-day average to such an elevated level.

Not surprisingly, this is historically rare.  The chart below shows the four other times since 1940 that it has happened.

The average six-month return following the other instances were all positive, and all greater than +13% (averaging nearly +20%).  It's tough to rely heavily on only four precedents, but they were all fairly consistent, which helps.

As an aside, that one-year average of the Up Volume Ratio is currently residing at 46%.  It has been at this level or lower only three other times since 1940 - the spring of 1970, December 1973 and the fall of 1974.  This is news to nobody, but it helps to underscore the fact that we're seeing the current level of shorter-term extreme buying interest in the context of a tape that is immensely oversold on a longer-term time frame.

Last week we looked at a few more glimmers of upside potential in the coming months, and the current overbought readings in breadth add to that pile.  Even so, because of the November failure to follow through on what should have been an intermediate-term rally from October's copious extremes, I've been waiting to see more confirmation of buying interest in the face of rising prices and overbought conditions, and we've seen that over the past couple of weeks.

This means that I want to be more aggressive with the next good-looking long opportunity, which should come when the current short-term overbought conditions wear off - ideally with the S&P backing off to 850 - 875.  I think it's unlikely we're going to get a pullback towards the lower end of that zone, and in fact the worst scenario from my perspective would be a steady rise to 1000 or higher on the S&P, with no pronounced relief of the stretched short-term conditions.

In the short-term, we have a questionable "overbought, under resistance, in a downtrend" setup that has been a killer for the market in the past.  So I'm not all that interested in trying to chase upside momentum here, which obviously risks the potential that we're going to continue higher without a pause.  With the market's tendency to pull back from sizable gains on a Friday/Monday and the various stretched short-term readings, I'm betting that sustained upside won't happen just yet.  A move back under 900 on the S&P 500, and especially yesterday's intraday low of 895, will usher in all kinds of "false breakout" talk, but again given everything we've discussed over the past few days, I don't think any potential breakdown would carry us below 850ish.