51% Below The High, 71 Years Later

03/03/09 8:50 AM EST

Good Tuesday morning...We begin the day with some buying interest in the pre-market futures.  Ironically, this is unnerving more traders than if we were facing a gap down, due to the market's tendency to fade quickly from optimistic openings.

Lately there have been quite a few market analogs floating around among traders, comparing the current decline to 1929, or 1932, or 1937, or 2002, or any number of other time periods that happen to fit some part of the current decline.

I lump analogs in the same category as most divergences - interesting, but not terribly useful.  That's just me - I have little faith in trying to trade off a picture that just happens to look similar.

While I sometimes break my own rule on writing about divergences, I'm going to do the same and touch on an analog that I've been watching for awhile.  The only reason I'm brining it up today is because one particular coincidence is just too hard to ignore.

The time period in question is the decline from 1937 through the early part of 1938.  The chart below compares the two time periods, and the time scale is exactly the same - I have not shrunk or expanded the days to make them "fit".  The red and green arrows show that for the most part, the major swings occurred within weeks of each other, and usually within a few days.

The most interesting comparison to me is the distance the S&P traveled below its 200-day average and previous 52-week high.  On March 31, 1938, the S&P closed 50.9% below its prior high.  Yesterday, it closed...50.9% below its prior 52-week high.

As of the low day, the decline in 1937-1938 lasted 319 trading days, with the S&P losing a total of 54.5% of its value.  The current bear market has lasted 350 trading days, with a total loss of 55.2% - so we've gone a bit longer, and lost a touch more value.

The magnitude of the final plunge is also tantalizingly similar.  In 1938, the S&P lost 27.2% over a period of about five weeks from mid-February to the bottom in late March.  Currently, the S&P has lost 25.1% from its high in January to yesterday's close.

Given what we've discussed the past several sessions, and continue to recap in the "bottom line" summary below, the setup is here for an intermediate-term low point.  We don't quite have all the ingredients (those put/call ratios continue to be disturbingly complacent), but enough to being looking for some typical signs.

Intraday, I'll be looking for things like a large spike in new lows on the NYSE, preferably getting between 1,000 and 1,200 (yesterday's closing figure according to the source I use was 983, which is oh-so-close...maybe good enough, but not definitively so).  I'll also be looking for huge overall volume (yesterday's was modestly high), extremely skewed downside volume (yesterday's was 23-to-1 to the downside, good enough), and extremely skewed short-term TICK readings (the Cumulative TICK reached -8000 at the lows this fall, and it "officially" closed yesterday at -6092, not quite there).

I'll also be looking for a particular price pattern over the next two days.

Using the continuous S&P 500 futures contract, there have been 13 intermediate-term lows since 1982, defined as the low day showing the lowest low of the prior 52 weeks, and that day's low not being violated for at least the following month.

Out of those 13 low days, only 3 of them began with a gap up opening, and of those that did, the gap accounted for most of the day's gain.  On those three days, at its worst intraday level the S&P lost -0.6%, -18.1% (in 1987) and -3.9%, so it's not like there wasn't some pain during the day.

Of the 10 that gapped down on the low day, all 10 of them were preceded by a down day the day before.  Those 10 days closed higher than the open 7 times, showing an open-to-close reversal that averaged +1.9%, and an intraday drawdown (i.e. worst loss at any point during the day) of -1.1% on average.

Importantly, they gapped up the following morning 8 of the 10 times, almost never traded lower than the open by more than -0.7% (only three instances were greater than -0.6%), and closed higher than the open 8 times (with the two losers being less than -0.4%).

The low last July was almost textbook:

These are obviously just averages, but the pattern is pretty clear - a down day, a gap down that sees some exhaustive selling to a new yearly low, then a recovery day that starts higher right from the get-go.

Of the lows we looked at above, 10 of the 13 showed some sort of re-test of the lows after a couple days of upside follow-through.  So chasing the higher prices didn't work most of the time, something to keep in mind going forward.

At the moment, the futures are indicated to gap up by nearly 1%, so is it possible that yesterday was the exhaustive selling day, and today is the recovery day?

That's possible, given some of the readings we went over above.  We saw signs of capitulation, but missed the usual benchmarks by just a whisker on almost all of them.  I'm not sure if it's good enough, but if we see the S&P continue to gap higher this morning, it doesn't lose more than about -0.75% or so during the day, and then it closes significantly higher than the opening price, I'd have to consider it a distinct possibility.

That is not my preferred scenario.  I would prefer to see the outright historical extremes we saw at past lows, ideally with the S&P trading down towards 675 or so.  But the market doesn't listen to me, I have to listen to it, and if we carve out a pattern like that defined above, given the readings we've been seeing, I'll be more inclined to add the intermediate-term positions I was intending at lower prices (though I will likely reduce the size).

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've seen that over the past two days, which should help us bottom sooner rather than later.

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. 

I mentioned last week that I was intending to add the initial part of an intermediate-term long position if the S&P hit 725, then another at 675.  But as we discussed yesterday morning, a large gap down that saw a lower intraday low after the first hour of trading had a significantly less likelihood of enjoying an upside reversal, and that's exactly what we got yesterday.  So I held off on adding and will have to take it a day at a time from here, basing my decisions on what we discussed above.

Bottom line - Short-term

Yesterday we went over a handful of stats suggesting a short-term low was likely to form within a day or so, and combined with the longer-term stuff from above, that could morph into something longer-lasting.

The lower low after the first hour of trading yesterday had me backing off any thoughts of an upside reversal later in the day, and we didn't quite trigger the kind of "panic" extremes during the day that would have me willing to buy into the free-falling prices.  So I basically did no trading.

Today is going to be just as tricky, as we're facing a gap up open.  This has the potential to be an important inflection day, as we went over above, but given the not-quite-as-extreme-as-we-usually-see readings from yesterday, I'm leery of trading it that way.  I suppose if we're able to hold through the morning without dropping below 705ish, I'll be more willing to look at the long side into the afternoon.

If we fail early and trade below yesterday's close, I'll be looking for a move into 675 - 695 or so that ideally would be accompanied by some of the panic readings we've seen before.

All the best,