Surge In Speculation, As Market Reacts To Payrolls

Posted At 8:55 AM EST

Good morning...We begin the day with a spurt of buying interest in the pre-market futures after the widely-watched payroll report came in significantly better than expected, at least in terms of the headline numbers.

There has been a lot of talk about "junk" stocks leading the rally out of the March lows.  We've touched on that theme a couple of times (here and here), and based on those studies see little reason to worry about it.

The one thing that does cause worry is if the most speculative stocks get overwhelming attention.  And the most speculative stocks extant are those that trade Over The Counter, not meeting the qualification to trade on the Nasdaq.

These stocks are also known as "pink sheets" or "penny stocks".  Or, more accurately, "really, really junk".  Very few of them ever make it out of penny stock Purgatory, instead languishing unloved under $1 per share.

The latest figures are out for last month, and they show a jump in trading interest in these stocks, with OTC share volume nearly matching the volume on the traditional Nasdaq exchange for the month of May, at right around 45 million shares.

We saw a tremendous volume spike in these shares in February and March 2006, which led to the conclusion that April that a push to new highs should lead to trouble heading into the summer.

That played out pretty well as it should have, as stocks went on one final gasp to new highs (unconfirmed by the Nasdaq 100 it turns out), then declined for the next couple of months.

We don't have quite the same situation here, as all the indices are at new recovery highs, and they're being led by technology.  Tech isn't lagging like it was in the spring of '06.  Also, when we saw the surge in penny stock volume back then, we also saw a surge in transactions and dollar volume, which we're not now.

So if share volume is surging, but the number of transactions and the amount of dollars turned over is not, then how do we reconcile that?

Well, the only possibility is that traders are trading more shares of lower-priced stocks at a time.  Indeed, the average price of the stocks traded on the OTC last month was $0.02 (the second-lowest price/share in history), and the number of shares per trade was 76,600.  The only time these gamblers traded more shares per trade was March 2006.

Another sign of speculative activity comes from the Rydex family of mutual funds.  If we look at the ratio of assets in the leveraged and un-leveraged Bull and Bear funds that track the Nasdaq 100 index, we see a recent surge in speculative long-side interest.

The Bull/Bear ratio in the un-leveraged funds continues to set new record highs, surging higher over the past few days.  There are now nearly 20 times more assets in the Bull fund than the Bear fund.

In the leveraged funds, on Wednesday these traders had 2.3 times more money in the Bull funds than the Bear funds.  That was the highest ratio since November 19, 2001.  It settled back down to 1.3 as of yesterday's close, which is still high but not quite at previous extremes.

Given the surge in speculative activity here, I'm dubious that the run toward 1500 in the Nasdaq 100 (which takes the index back to the breakdown levels from last October, and is also the 38% retracement of the entire bear market) will be sustained on this first attempt.

Bottom line - Intermediate-term Outlook:  Neutral  (since April 9, SPX 843)

Beginning in early March, we discussed a large number of reasons to expect an imminent rally of one to three months' duration.  Some of those studies were even more positive, and suggested not just a rally, but possibly a new bull market.

During mid-April, several of our measures like the Indicator Score and Dumb Money Confidence reached levels that usually result in either a flattening out of the price rally, or an outright decline, especially during a bear market.

But the market held up extremely well in spite of some of these overbought types of indications.  This is very rare during an ongoing bear market, and is important to keep in mind especially given many of the "this time is different" kinds of studies we reiterated in early May.

Last Friday we looked at how the market typically reacts coming out of an extremely tight multi-week range.  Usually it breaks lower first, but even more consistently the first move tends to be a "false" one, with an upside breakout leading to more weakness than strength after the initial surge.

Given that and a bevy of technical factors, I've been looking for the S&P to run into trouble if it traded into 940-950, which it happened earlier this week.  I wasn't expecting any kind of waterfall decline to new lows, just looking for more of a pullback than we've seen.  On Wednesday afternoon, we discussed the first pullback to the breakout over 920ish, and the market once again passed with flying colors.

It's hard to become too negative on the market as long as it continues to do nothing wrong, but we're leery of it being able to sustain a breakout over 950, especially coming on the back of an economic report like this morning.

Bottom line - Short-term Outlook:   Neutral  (since June 3, SPX 924)

The market has done OK, with a modest positive bias, the morning of the June payroll report, as we're seeing once again this morning.  But from the close on the payroll report to three days later, the S&P was positive only 33% of the time since 1997, with an average return of -0.4%.  The last four years were all negative during those three-day stretches.

If the S&P gapped up +0.5% or more on a June payroll report, it managed to close higher than the open 1 out of 4 times.  The one winner was impressive, gaining another +1.3% during the day, but it gave all those gains back (and then some) over the next week.

If we ignore the fact that it's June, then overall there were 16 times that the S&P managed to gap up +1% or more the morning of a payroll report.  It closed higher than the open 10 times, averaging +0.5%, and we never saw a loss of more than -1% from the open through the close.

But as we so often see, enthusiastic reactions to economic reports tend to not last, and this was no different.  Over the next few days, the S&P was positive only 37% of the time with an average return of -1.1% and with a maximum risk (-2.2%) that more than doubled the average maximum gain (+0.9%).

If the S&P happened to set a three-month high on the day of the payroll report, which it looks like we're going to do today, then the next three days were positive 1 time out of 6 occurrences (and the one winner gave back the gains the following day).

Per usual when we see a big gap up open to a new high, I'll be using the first hour of trading as a reference.  If we can sustain the gap open and set a new intraday high after the first hour, then I'll be looking for the possibility of a trend day forming and a close higher than the open.  If we fail, then it should be within the first hour, and the first half-hour more likely.

If we happen to see a strong close today, then given the tendency to reverse from jumps on economic releases, the overbought conditions and poor seasonality, I will be looking for the gains to be pared back early next week.

All the best,