They Dropped The Other Shoe!?!

They Dropped The Other Shoe!!
Ready For The Big Rally!?!
By Normxxx | 5 February 2008

For the fourth trading day in a row, the S&P 500 has undergone a 1% move, either up or down. That's a fairly rare form of volatility, but even more striking is that we've seen 15 of these 1% moves during the past 21 sessions, the length of an average month. To see just how rare that is, and what it might mean, I went back to 1950 and looked for all other times it's happened. The last three occurrences were all at or near three of the five major intermediate-term lows during the last bear market, and by a month later the S&P was positive each time by an average of +11%. That's the good news.

The (potential) bad news is that in the shorter-term, volatility continued apace. The absolute value of the volatiulity of the five-day returns averaged 4%, twice any other random period— meaning that after volatility was as high as it is now, it continued to be about twice as high as normal over the next five trading days, and three times as high over the next two weeks.

So it's not at all out of the question that even though we may be trying to hammer out a decent intermediate-term low somewhere around here, it's probably not going to be all hearts and flowers— we're almost certainly going to have to deal with more of these types of gut-wrenching jerks both ways. But there is the good news in the data. Almost all of these instances popped up after the market had made a panic low. Over the next couple of weeks, there was often some further testing of those lows, but every time the low held or was quickly regained if violated, and stocks went on a tear higher afterwards. This fits in nicely with all the other indications I've been getting.

After gapping down more than 1% this morning, a violation of the first hour's low should have served to usher in even more selling pressure as the day wore on. We got the violation mid-morning and the additional selling pressure. It has been enough to generate extremes among almost all the short-term indicators I follow and, to upstage briefly what follows, I'm going to switch to looking for decent SHORT term risk/reward stups on the long side now. The pressure has been pretty relentless, giving us about as close to a 'negative trend day' as we ever see anymore. The pattern of the past two days is almost a mirror-image of the prior two instances, and we're not far from the lows from last Thursday's gap down open in the S&P 500. The Nasdaq 100 (NDX) has been hit a bit harder and even flirted with last week's lows.

We're likely headed for a period of continued high volatility over the near-term, so you should bake that probability into whatever trades you take, but I do think we're going to at least bounce on this approach towards the January lows, that may possibly even segué into a multi-month rally afterwards.

This morning, I believed that due to the large gap down opening, if the indices went on to score lower intraday lows after the first hour, then I would be looking at even more selling pressure into the afternoon. They did so, and and the pressure today has been pretty relentless, giving us about as close to 'a negative trend day' as we ever seen anymore.

The selling has certainly done its job in taking care of the overbought conditions we found ourselves in late last week, and we're approaching the opposite condition. My major sentiment indicator for the S&P is now in "excessive pessimism" territory for the first time since January 18th, although the similar indicator for the NDX is not quite there.

Most of my other sentiment indicators are firmly oversold. The least extreme are the Cumulative TICKs, which are coming off of historic overbought extremes from a couple of days ago (for the NYSE, anyway). The Price Oscillators, Arms Index and implied volatility are all firmly in "too far, too fast" territory. The Arms Index (aka TRIN) is probably the most interesting, with a current value over 2.5 on the NYSE and a huge 3.8 on the Nasdaq. That roughly means that sellers are more than twice as interested in selling as buyers are in buying on the NYSE, and nearly four times so on the Nasdaq.

Since 1985, there have been just 20 instances when the Arms Index on both exchanges closed above 2.0. The following day, the S&P was higher 16 times (an 80% success rate) by an average of +1.2%. The Nasdaq 100 was also up 80% of the time, but its average return was +3.0%. It's notable that 2 of these 4 losing trades occurred last month, so the very recent history of this "buy" signal is not good. (Prior to last month, it was nearly flawless.) It's also notable that these signals were best in the very, very short term of one to three days. Past that, and we got into some very dicey situations, as several of these happened during the teeth of the waterfall decline during the spring of 2002. The indices often rebounded in the very short-term, then fell apart soon afterward.

If we should see these readings become quickly even more egregious— then we should just as quickly withdraw— remembering my warnings about volatility— but as of now they're arguing for at least a bounce off any potential support zones. These kinds of trend days tend to close at or near the day's lows, so I don't want to be too anticipatory. I will be looking to the Nasdaq 100 for a potential long-side 'scalping' trade if it's able to hold around here.

Notable among the unusual readings that triggered during the panic selling in January was the huge number of stocks on the NYSE which had hit a fresh 52-week low sometime during the debacle. With more than 30% of stocks reaching new lows, we were seeing a sign of capitulation rarely seen. That was only one example— there were plenty more from which to choose. Given those readings and the back-to-back intraday upside reversals, the case was fairly strong that at least a temporary selling exhaustion had been reached, and at least a reflexive bounce was imminent.

We got that bounce, and then some— the major equity indices jumped 10% or more from their January lows into the beginning of February. That's right in line with what we've seen after prior panics. What's consistent among those prior periods is that major lows don't usually form in a panic. They form after an initial bounce peters out and finally scares everyone who bought into the panic/rally. It doesn't always happen like that, of course, but it's consistent enough to be considered likely.

Last week, stocks enjoyed their best performance in more than five years. I researched other times the S&P 500 has enjoyed its best week in five years, and very often I saw them clustered around major intermediate-term lows after panic had set in. Just as we just saw over the past couple of weeks.

Over The Next Couple of weeks after those instances, there was often some further testing of the prior panic low that triggered the volatile moves, but every time the low held or was quickly regained if violated, and stocks went on a tear higher afterwards. (Only the December 1973 occurrence didn't precede what I would consider an intermediate-term low.) After those instances, volatility during the next two weeks was triple that during random periods, so it seems likely that we're going to continue to see some wild swings in the short-term.

This would fit in nicely with everything we've gone over during the past couple of weeks. We did see hints of panic at the January low— perhaps not overwhelming evidence of it, but enough to consider it a panic. Then we saw the best week in five years. And during this time, we've seen such volatility that the only comparable periods are other times when the markets were forming intermediate-term lows. So the probability that we're going to get a successful re-test of the January low seems high, and I've become more positive on the prospects for a multi-week or even a multi-month rally because of it. We're still in a bear market, but that doesn't preclude us from seeing substantial rallies in the interim.

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Normxxx    
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