Three Amigos Pointing South

Posted At 9:15 AM EST

Good morning...We begin the day with some weakness in the pre-market futures as the combination of the usual post-Fed reversal pattern and weak economic reports are too much to inspire much buying interest.

Over the past few weeks, we've taken a look at a few different indicators that aren't often reviewed.  Given that most of the measures we follow on the site haven't changed much (other than the shortest-term ones), I thought it'd be a good time to update a few of the lesser-known ones.

The chart below shows the Citigroup Economic Surprise Index, the Net Profit of Japanese Margin Traders, and the UBS Dynamic Risk Index.

The Economic Surprise Index is an index that computes how worldwide economic releases have come in relative to expectations.  It typically ranges from a low of -100 to a high of +75 or so.

It has backed off a bit over the past couple of weeks, having reached a high of just under +70.  That's just about as high as it gets, suggesting that we've seen a plethora of economic "beats".  While some would suggest that's a good thing, historically it has meant that traders have become accustomed to good reports, and so disappointments are going to be treated harshly.  That's a dangerous situation.

The steady stream of better-than-expected reports has no doubt helped contribute to the gains in stocks, and that has obviously helped margin traders.  One of the more unique indicators is the second one on the chart, the net profit of Japanese traders who are trading on margin.  That index has demonstrated a theoretical upper limit of 0, meaning that almost every time in the past decade that these traders showed a net profit, they immediately started losing again.

When we touched on this a few weeks ago, the index was at -13%.  By last week, it had climbed to -5%, their best performance since June 2007, and close to the point where they (and the market) has usually pulled back.  Another warning sign.

The last measure is the Dynamic Risk Index calculated by UBS Securities.  Since the peak of the bull market, we've seen the S&P 500 peak the other two times the index has climbed above 0.  The index did just that in mid-June (hmm...just as the S&P 500 was peaking again), and has since backed off a bit but is still near the upper end of its range.  Warning sign #3.

When we looked at a combination of intermediate-term timing indicators we follow on the site on June 18th, the message was pretty clear - the inability to sustain the breakout over 950, given the multitude of "excessive optimism" readings, could lead to a trend change from up to neutral at best, and perhaps even a new sustained downleg.  The best evidence of the latter would be if the S&P can't rally off of short-term oversold conditions and/or clear technical support.

There has been some initial evidence of the former as we've had a couple of relatively weak rallies off of short-term oversold conditions over the past couple of weeks, but the biggest test would be a move into 880ish as we head into a relatively bullish seasonal time frame ahead of the July 4th holiday.

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 earlier this month.  I wasn't expecting any kind of waterfall decline to new lows, just more of a pullback than we'd seen.

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 the most recent surge in the spread between the Dumb Money and Smart Money Confidence, and the tendency for initial breakouts from volatility coils to be "false", I was looking for the first breakout above 950 to be beaten back.  Now that that's happened and we're nearing the opposite end of the May - June range, we need to see how the market responds to short-term oversold conditions, especially now that we've seen a "failed" rally above the 200-day average.

The recent 90% down volume readings when coming off of an intermediate-term high aren't necessarily a sign that the trend is changing, but if we can't get meaningful bounces from oversold conditions, and especially if we lose the 880ish area on the S&P, then a re-test of the March low looks to be in order.

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

Yesterday morning and again in an intraday update, we went over various stats related to days when the Federal Reserve committee releases its rate target.

The day followed through as it normally does by (just barely!) closing higher than its open.  As we touched on in some Twitter notes, though, the post-FOMC reaction was one of the weakest we've ever seen, given how positive the market was holding just prior to the announcement.

Still, the S&P opened and closed more than +0.5% above Tuesday's close, and historically the S&P has declined over the next couple of sessions 9 times out of 10, by a not-insubstantial -1.9%.  I'd normally be looking to short into an up close on an FOMC day, but I was put off by the weakness we saw after the release, not sure if that would alleviate some of the usual weakness we see in the days following.

There have been 12 times that the S&P closed an FOMC day higher by +0.5% or more, then gapped down the next morning by -0.5% or more, as we're set to do this morning.  Buying the open and holding 'til the close resulted in only 3 winning trades with an average of -0.6%.  7 of the last 8 were negative from open to close, with the lone winning trade being a miserly +0.08%, so obviously it's been unusual to see meaningful upside reversals after setups like this.

I don't want to make too much out of the FOMC event, but historically the market's reaction has been very consistent, and so far it's following through on those tendencies.  If it continues, and I don't see a lot of reason why it shouldn't, then we should see further weakness heading into the end of the week...which could set up a big test if we get some short-term oversold conditions as the S&P nears 880ish, heading into the end of the month.  That would be a clearly bullish setup, and if the market can't follow through on that, given what we discussed above, then a bigger trip towards the March low would likely be on the agenda.

All the best,