Watching For A Change In Character

Posted At 8:45 AM EST

Good morning...We begin the day with some modest buying pressure in what has been a volatile pre-market session in the futures.  Traders seem to be torn between some positive guidance from Texas Instruments and the idea that North Korea might finally go bat-shit crazy with its weapons program.

Whatever the reasons, we saw a rare bit of excessive pessimism during the trading day yesterday.  Well, in a relative sense at least.

The Equity-only Put/Call Ratio moved to 0.75 at yesterday's close, one of the more extreme readings we've seen since the bottom in March.  We can't necessarily conclude that traders were buying protective put options hand over fist, but it has been a good contrary indicator over the past few months when we've seen 75 put options traded for every 100 call options.

Historically, a reading of 0.75 isn't any special - it's about dead-set neutral compared to others over the past couple of years.  But some sentiment indicators, put/call ratios in particular, trend along with the market, and it's usually a better idea to place current readings in the context of recent extremes.

Every time the ratio has reached this level of extreme, the S&P 500 showed a positive return over the next couple of days, averaging +2.6%.  Drawdown was very minimal, averaging only -0.4%, while the maximum gain over the two days averaged +3.3%.  None of them lost more than -0.8% at any point during the two days, while every one of them gained more than +2.1% at some point.

Watching how the market acts here will give us some idea if the market's character is shifting.  If we can't muster a move above 958 (about 2% above yesterday's close), or if we drop below 931 (about -0.8% from yesterday's close), then the market will be doing something it hasn't done since the bottom.

One thing that has changed is that breadth is beginning to lag a bit.  We're seeing slightly less participation on the upside than we have previously.

Peter Eliades in his Stockmarket Cycles letter last night mentioned that we saw a rare occurrence yesterday in that the Dow Jones Industrial Average closed at its highest level in months, yet the McClellan Oscillator moved into negative territory.

Recall that the Oscillator is sort of a momentum indicator for breadth.  When more stocks are advancing than declining - and at an increasing pace - then the Oscillator will rise, and vice-versa.  So the Oscillator moving below zero shows that upside participation among stocks is waning.

Indeed it is rare to see this happen on a day the Dow sets a new multi-month high.  The last time it occurred was July 16, 2007.

It also happened in mid-December 2004, right before the Dow formed a multi-month peak.  Same for early April 1998, late April 1981, late February 1976 and early September 1961.

Those were all good sell signals, or at least heads-up that buying momentum was leaving the market and any further upside was going to be constrained.  But it wasn't always so.

Since 1940, there have been 32 times that the Dow closed at a 100-day high on a day when the Oscillator crossed below the zero line, detailed in the table below.  The next day, the Dow was positive only 25% of the time, and three days later only 31% of the time.

But the longer out we look, the more positive the results become.

By three months later, the Dow was up 81% of the time, averaging +3.2%.  During those three-month trades, the average maximum risk was -3.3%, compared to an average maximum reward of +5.4%.

Based on these results, it does look as though the push to a new high in the Dow may be suspect, but only on a very short-term time frame.

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.

While there have been - and continue to be - many reasons to consider this rally something different than we'd seen previously in the bear market, I've been looking for the S&P to run into trouble if it traded into 940-950, which it happened last week.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

The S&P did fail on its first attempt to get over that hump, but on Wednesday afternoon we discussed the first pullback to the breakout over 920ish, and the market once again passed with flying colors, taking us once again into 950ish by Friday.  It's hard to become too negative on the market as long as it continues to do nothing wrong.

What's made this juncture so difficult is that despite so many signs of "this time is different" and the market doing nothing wrong, there are some troubling signs out there.  We touched on a couple very recently, like the surge in speculative trading and the return of bullish opinion.  Because of that, I've been leery of the S&P's chances to hold a breakout above 950.

With so many conflicting signs (like the prior two paragraphs), I'm simply going to back off and see how the market reacts.  In other words, I just don't know.

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

Yesterday we touched on the idea that the market should have some trouble maintaining the upside prop that we saw on Friday, and that it would be instructive to see how the market reacted if the S&P happened to approach 920ish again.

We saw some fairly heavy selling pressure early, and once again the S&P neared that general 920ish level.  At the same time, the STEM.MR Model dipped into oversold territory and apparently that's all we needed.  Once again, the market has shown an ability to do absolutely nothing wrong, as it rallied strongly from a modest "oversold on support" setup.

I've been willing to bet, on a short-term time frame, that the S&P wouldn't be able to make a sustained run above 950ish, and the NDX above 1500ish.  For the most part, that's been generally the right idea...so long as any bets are only one-day affairs.  I was not expecting such a strong rally yesterday afternoon, and given that bounce from modest oversold conditions and the put/call data above, I'm less inclined to bet against yet another attempt to make it over those resistance levels.

All the best,