Stuffing The Mattress

03/02/09 7:45 AM EST

Good Monday morning...We begin the day with another round of heavy selling pressure in the pre-market futures, with the indices currently indicated to open more than 2% below Friday's closes.  The drumbeat of negative news just continues to sound louder, from a loss at AIG that was 37 times larger than estimates (!), to a cacophony of calls that the Oracle of Omaha has once again lost his "magical" touch, to the first cut in dividends at GE since oil was discovered in Saudi Arabia (1938).

We've often looked at the impact this is having on investors, in terms of moving money out of stocks and into cash.  That hasn't stopped in the least.

The latest monthly figures for the mutual fund industry were released on Friday, and they showed that mutual fund managers were doing what everyone else was scrambling to do, too - raise as much cash as humanly possible.

These folks have been increasingly subject to a tough charter of not timing the market, no matter how bearish they may be.  That's part of the reason we haven't seen the big spikes higher in liquid assets at mutual funds, but another is the record low interest rates paid on cash.  There isn't as much incentive to hold a super-liquid investment when it's yielding 0.1% as when it's yielding 10% like we saw in the 1980's.

Even while yields trudge along near all-time lows, however, we're still seeing fund managers allocate more of their portfolios to cash, which made up 5.8% of their total assets in January, from 5.2% in December.

When we factor in interest rates, we can try to figure out a baseline amount of cash that funds should hold in order to meet redemptions, etc.  This is the premise behind the Mutual Fund Cash Surplus / Deficit indicator, shown below.

Currently the indicator has moved up to 1.1%, basically meaning that funds are holding 1.1% more cash than they "should" given their historical need to meet redemptions, and the yield they are receiving on cash investments.

While this is still below the +2% level that has marked some prior extremes, it's obviously much-improved from the -3% we saw in the spring and summer of 2007 (and the spring of 2000 prior to that...).

This +1.1% figure is the highest since 1995.  If we go back to the 1950's and look for anytime the Surplus / Deficit climbed above +1.1% from below, then three months later the S&P was up 78% of the time, averaging +5.7%.

It's not really appropriate for that short of a signal, so looking at one-year returns, the index was up 16 out of the 18 instances, averaging +17.0%.  Most importantly, the average risk one had to endure (-7.5%) was swamped by the average reward that was offered during the year (+24.5%).

Looking at two-year returns, the S&P was 18 for 18, averaging a gain of +25.7%, with a risk not much worse than the one-year (-9.0%) and a maximum return that jumped quite a bit (+36.2%).

It isn't just fund managers raising cash, it's a lot of folks.  Individual investors as well as hedge funds have been piling into money market mutual funds, and as of the end of January there was enough cash parked in those funds to buy up 47% of the entire S&P 500 index.

This amount is so far and above any other extreme in the past 25 years as to render it useless for timing purposes.  We've known for many months that the amount of assets hiding in safe investments is enormous, and exceeds levels that have historically indicated extreme fear, and an imminent return to risk-seeking behavior.

Lots of cash on the sidelines isn't bullish until it begins to return to the market, however, and as yet we're seeing few signs of that.

Among all of our sentiment indicators, the biggest holdout remains the put/call ratios, which continue to display startlingly complacent readings.  Never before in the history of that data has the five-day average of the Equity-only Put/Call Ratio been outside its bearish (for the market) trading band on a day the S&P 500 traded at a new yearly low.

Until Friday.

There have been two times it did so when the S&P was within 5% of a yearly low.  On March 23, 2001 we saw that, and the S&P chopped around for the next week or so before bottoming at a modestly lower price and then going on a multi-month rally.  We also saw it on September 25, 2008, which immediately led to all sorts of ugliness.  There isn't much we can read into those two if trying to extrapolate it to our current situation.

Like the volume figures lately, much of the put/call distortion could be options traders preying on the financials.  Citigroup set a new all-time volume record on the NYSE on Friday, trading 1.77 billion shares (by the way, the previous record was 1.51 billion shares by Worldcom in July 2002).

Of the top 10 most active call options at the CBOE, 6 of the them were in Citigroup options, compared to only 2 of the most active puts.  I believe a big part of why the put/call ratios are skewed right now is because many traders are treating call options on the financials like lottery tickets, scooping up a few "just in case".

We saw this another time when the market was trying to forge an inflection point, in March 2003.  Even though the indices were selling off and making a lower low than in February of that year, the put/call ratios were not reflecting any amount of panic.

I don't necessarily want to compare our current juncture to 2003 in terms of suggesting that what we're seeing now in the options market could be a good sign like it was back then.  Absolutely not - I am very troubled by the fact that even with another horrible week (and month), the smallest of options traders have still not capitulated like they did at prior lows, not even close.  We just need to consider all angles, and understand that a market can do whatever it wants even if one particular indicator isn't in line with the others.

By the way, if you go to the Complete List of equity-market indicators, you'll find that the table is now sortable based on any of the column headings.  You can put the shortest-term ones on top, or the most bullish indicators, or the ones that have been updated most recently...or any combination of two of them.  It's a feature many of you have asked for, and I think it's a helpful change.

Bottom line - Intermediate-term

We went over several studies in December (here and here and here) indicating that what we witnessed during November marked a major bottom.  But after what we went through to begin the New Year (e.g. the spike in Dumb Money Confidence and Intermediate-term Indicator Score, the failed breakout at 920 on the S&P, the subsequent losses of support at 880 and 850, and the failure to bounce off short-term oversold conditions), that probability diminished substantially.

Because of that January failure, I had been leery of buying into weakness until we either saw more of a pessimistic extreme in the Dumb Money, or an improved technical picture.  The Dumb Money is getting there with a current reading of 21% as we discussed on Friday, but that still doesn't quite match the previous pessimistic extremes under 17% that we saw at each of the prior temporary lows since 2007.

As for the technical picture, the S&P 500 broke under the 800 area that had been support, and it's now twisting under any and all common support levels.  Ironically, probably the best thing we could do to establish an intermediate-term low sooner rather than later was to break that 740 level and see some intense short-term selling pressure.  We're getting that now, which should help speed the process.

Given the AAII data mentioned recently , a few other potential positives (now including the 90% Up Volume session from last Tuesday), and the current Dumb Money Confidence reading of 21%, I'm confident that we will witness another multi-week (and possibly multi-month) low by mid-March. 

As I noted on Friday, buying into that gap down open would probably still lead to a positive return over a multi-month time frame, but the intra-trade drawdown could be "uncomfortable" if heavily invested.  We're currently experiencing the "uncomfortable" part.

On Friday I wrote that I was going to be looking to add long positions on an intermediate-term time frame instead of just short-term trades, but not just yet.  If we hit 725ish by Monday, then I'd likely add the first tranche (of four), with the second on a move to 675ish.  I'll be looking to add that first part today. 

Bottom line - Short-term

Some stats to consider:

   On the blog on Friday, we looked at gaps when the Dumb Money was at 21% or below, its current value.  When we've seen a gap down open of -2% or more, like we did on Friday, then the 3-day return in the S&P averaged +5.9% with all 8 occurrences giving a positive return.

   There have been three times that the S&P 500 SPDR (SPY) was down three days in a row heading into the end of a month, then opened the first day of the new month with a gap of least -1%.  The dates of 09/03/96, 10/01/98 and 02/02/09 all coincided with short-term exhaustion of the selling pressure.

   There have been 7 times that it was down 1.5% or more two days in a row (not necessarily around month-end), then gapped down -1% or more.  Buying that open and holding for three days led to 6 winners out of the 7.  The loser was Black Monday in 1987.  Excluding that outlier, the average 3-day return was +6.2% with an average maximum reward (+9.9%) that was nearly three times as large as the average risk (-3.6%).

   There have been only three other days since 1982 when we saw consecutive gap down opens of -2% or more - 01/23/08, 09/16/08 and 09/17/08.  Both time periods led to a short-term pop higher over the next few sessions, averaging about +5% at its best point.

We went over quite a few of these general types of studies heading into Tuesday morning, and got a nice-sized rally that day.  But based on what we went over on Wednesday, we should have seen another 2-4 days of upside follow-through, which obviously did not occur.

Also, there were three opening gaps of -2% or more over the prior two weeks, the only time that has occurred other than 10/10/08.  All of those gaps remain "open", which is exceedingly unusual - as we discussed last week, gaps of -2% or more tend to get closed within one week more than 80% of the time.

As I mentioned on Friday, I'm getting significantly more optimistic on an intermediate-term time frame, but the short-term path to get there is fraught with risk and volatility.  I didn't see much at all on a short-term time frame among our sentiment guides Friday that would have me sticking my neck out on the long side, especially if we broke 740 on the S&P.  We did break then re-gained the level, which helped for a couple of hours, but then we rolled right back over again.

Like Friday, when we gap down as large as indicated this morning, and under a previous low, the market has a consistent tendency to snap back, so there is extreme risk this morning from both the long and short side.  While there are a large number of historical precedents suggesting we should snap back soon after today's open, the fact that we were so weak on Friday, and that we have seen so many unusual developments lately (i.e. the extreme number of -2% gap openings), we can't rule out an extreme event ala 1987.  If we set a lower intraday low after the first hour of trading day today, then I would not be attempting any long-side trades unless or until we again reversed above 740.

All the best,