Overbought and A Little Less Bearish

By Dr. Duru written for One-Twenty

April 3, 2009

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I guess I am still an incurable bear for now because I stare at this rally in the S&P 500 about 25% off the lows and cannot generate the same level of excitement and enthusiasm that seems to carry the day. However, I admit that I am a little less ornery than I was on January 21 when I figured that the S&P 500 52-week and multi-year low of 740 would be tested and broken. I think the current low of 667 will eventually be retested and likely broken, but after observing the action of the latest bear market rally, I am more optimistic about the next retest marking a lasting bottom (note I will never say THE bottom). This rally showed that at some point, the Treasury, the Congress, the President, and the Federal Reserve can stuff enough paper currency into the economy and the markets to goose the stock market higher. As has been the case throughout this bear market, government intervention has been the prime catalyst for the rally cries. Sprinkle in a little stimulus from China, and we get an explosive move in commodities. For good measure, throw in another one trillion dollars stuffed into the International Monetary Fund (IMF) by the G20, and we have a globe floating in paper currency. It is almost like money is hanging from trees, ready for the picking. This money eventually has to go somewhere beyond the vaults of threadbare banks, and these past few weeks we have seen enough paper return to the stock market to launch it like a rocket.

Assuming the financial system has stabilized and some credit markets are healing, we still have the core economy of consumer income and spending left to wrestle. March's job report will probably be bought by the market no matter what it says - a bad number will indicate things cannot possibly get worse, a good number will be proof that the recovery is already underway, and everything in between will be a sign that the consumer's situation has stabilized - but at some point the market will re-awaken to the gnawing persistence of the decline in the consumer's financial health as unemployment continues its inexorable rise to double digits. I am targeting September or October just because these months are a seasonally weak time for the market, but of course it could happen anytime. (MarketClub has its own technical analysis suggesting a 12-month horizon for fresh lows). Even further out into the future it remains to be seen how much healing we get from trying to solve a problem of indebtedness and leverage with more debt (name your favorite Federal Reserve lending facility or Federal bailout/handout) and try to reflate a collapse in fantasy asset values with fantasy accounting (e.g. elimination of mark-to-market).

Investing gets much dicier as we nudge ever so closer to the well-watched resistance level of 875 on the S&P 500 - maybe the market pushes to 900 just to salt the wounds of bears. T2108, the percentage of stocks trading above their 40-day moving average hit 83% on Thursday. The last two times this happened, we got a top the first week of January, 2009, and the all-time top in October, 2007. Recall that since 1986, selling the S&P 500 when T2108 crossed the 70% threshold, above or back below, has provided a practical capital preservation strategy. This means that we are in over-bought territory. The risk/reward is now very poor for playing chicken with the S&P 500's next resistance level. This next push represents just another 5% of performance. Not a good spot for initiating new longs, and a great spot for selling shorter-term holdings into the rally.

Let's review where the market sits using past T2108 analyses as context:
  1. We last entered oversold territory on February 19, 2009. "Oversold" is defined as T2108 falling to or below 20%. The S&P 500 is up 7% since then. The market spent 15 days in oversold territory and lost almost 10% during that time.
  2. The "buy-the-bottom" rule never triggered. Historically, buying the S&P 500 works well when T2108 is oversold and the VIX spikes to within 20% of its spike during the last climactic bottom. This time, the VIX spiked to within 34% of the last market bottom in November. The VIX got as high as 53% a few days BEFORE the ultimate low, and this was LOWER than the spike that occurred during the "inauguration swoon." It is very possible that I should have been focused on the climactic selling in January and not the lows of November. Regardless, this VIX action helps makes me more skeptical of this latest bottom being THE bottom - not to mention that the VIX remains stubbornly high.
  3. The S&P 500 spent a total of 51 days between over-bought conditions where T2108 is above 70%. Since 1986, the market has spent longer periods between over-bought conditions just 23% of the time. Earlier I suggested that as these days increase, the chances of a rally increase. I have not yet studied this or defined any specific rules. Intuitively, it makes sense, and it worked this time around.
  4. We hit the first overbought condition on March 26 with the S&P 500 closing at 832, comparable to Thursday's close at 834. The market spent one more day overbought before dipping below the threshold again for a brief, and atypical, 2 days. Returns on the S&P 500 are strongly correlated to the number of days spent in the over-bought condition. Given there is about 5% of return to the next resistance level, I suspect that if we are getting there before selling off, we will get there very soon. We are on day number two and counting of being in over-bought territory again. If you had sold at the last over-bought crossing, you would not have missed anything as of Thursday.
Overall, extreme caution is warranted here. The risk/reward appears poor for chasing the rally here. I have become a little more optimistic for the next bounce from fresh lows and oversold conditions.

I conclude by doing a quick review of some of my notes from the past several weeks:
  1. "Now I Can Get Interested in Goldman Sachs" (Feb 04): I did not buy GS at the time because I expected the S&P 500 to make fresh 52-week lows. When it happened, GS did not make its own fresh 52-week lows, but I failed to trigger a buy. I am kicking myself 35% AFTER GS ran 15% up from its last bottom. The GS uptrend from the November lows remains strong, and it remains a buy on the dips until this trend ends.
  2. "Joy Global Backs Away From Its Buyback" (March 04): JOYG decides to buy high and "sell" low by halting its buyback program in order to preserve cash. I wondered aloud whether JOYG expects even lower prices for their stock. Since then JOYG is up 34%! (For a general review of this "buy high, sell low" behavior on buybacks see "Buybacks Slowing At Just The Wrong Time")
  3. (March 13): I decided to go long the EUR/CHF currency pair, but it barely budged from levels at that time. I soon bailed on the position. Since then, I have traded mostly long in and out of the pair with some success. I am loathe to short even though it is starting to look like the Swiss may not have the firepower to maintain their devaluation strategy. The G20 is also trying to coordinate currency devaluations. I guess this means everyone sinks at the same time and no one notices any inflationary impact. We will see how long THAT lasts.
  4. "Still Being Paid to Wait on Intel" (March 16): INTC is up another 10% since March 16. Per above, I do not expect these gains to last in the short-term, but as I explained earlier, INTC is a holding for the next 3-5 years.
  5. "TIPS Erase First Deflation Panic" (March 27): Not much change on the TIPS.
  6. "I Prefer to Observe XLI Trading Action Here, Not Follow It" (March 30): This one is too new to assess well, but I wanted to point out that the XLI is about 5% higher from the day that all the Feb 20 calls traded, but the calls are essentially the same price at 60 cents each. These calls plunged as low as 20 cents each after XLI dropped 5% the day after all the call action. Two weeks to go until expiration....
Be careful out there!

Full disclosure: Long INTC and TIPS. For other disclaimers click here.

DR. DURU®, 2009