August 22, 2007

My finger is on the trigger, but do I buy or do I sell? 

The market gives “clues” as to its next move (certainly not ringing bells or flashing signs, but some subtle clues).  In my August 13th article I wrote about my desire for the market to exhibit a 9-to-1 up-day (the ratio of advancing issues versus down issues) because that would be much welcomed clue that the market could begin a sustained (emphasis on “sustained”) rally.  9-to-1 up-days (especially back-to-back 9-to-1 up-days) are very bullish as they typically indicate that selling has become exhausted and now demand has picked up enthusiastically. 

On Friday, August 17th, we had one such 9-to-1 up-day.  However (and this kills me) it occurred on an option expiration day which accounted for much of the upside volume.  Furthermore, much of the volume occurred in the first hour of trading, with much of that coming from short-covering due to the drastic intra-day rally of the previous day (suggesting that the volume was based on one-time buying and not renewed demand).

So does it count or doesn’t it?  Should my trigger finger be ready to buy or to sell?  I’ve had a couple trading days to watch market action and so I wanted to clue you in on the data I am considering. 

Bearish Clues

• Once the market corrects by ten percent (something it historically does at least once per year, although this time it went four years without such a correction; the second-longest streak in market history), there is a 33% chance that the market will continue sliding toward total loss of twenty percent.

• Both volume and demand have dried up since the Friday, August 17th big upside volume day.  If demand continues to be light that argues not only that this will be only a rebound rally, but that it will be short-lived.

• On both July 24th and July 26th the markets experienced 9-to-1 down-days (the market had peaked a week earlier on July 19th).  Then on August 3rd (two Fridays ago) the stock market tanked about 2.7% in just that one day, which set up the third 9-to-1 down day since the market peaked.  And I am afraid to say that, historically, three 9-to-1 down-days (without an intervening 9-to-1 up-day, which would be very bullish) is a very negative occurrence for the stock market.  It could further be argued that the 9-to-1 down-day on June 7th was part of a succession of 9-to-1 down-days, putting us at four such days.

To put the three (or four) 9-to-1 down days into perspective, it is important to note that many of these may occur during a bear market (but usually spread out about a month apart from one another).  For example, there were seven such days in 1962, six in 1970, fourteen during 1973-1974, and seven in 1990.

Bullish Clues

• The stock market rallies when investors have become extremely fearful of equities.  One such indicator of fear, the VIX, in the last years has climbed from a low of 9.39 to a recent high of 37.50.  It hasn’t been that high (the higher it is, the greater a predictor it is of a stock market rally) since March 2003 (as we began our war with Iraq and the market corrected about 15% over about three months).

• Another such measure is the UBS Risk Index, which has been tracking investor activity since 1998.  Like the VIX, the higher the number the more likely a rally is to follow.  After the 1998 collapse of hedge fund Long Term Capital Management (and the subsequent “Asian Contagion) the UBS Risk Index registered a 2.16.  After the September 11 attacks the index hit 2.27.  The index didn’t even break a 2 during the 2001-2002 crash, but it recently logged a new record at 2.53.

Resulting Strategy

I am unwilling to rely upon the singular 9-to-1 upday registered on Friday, the 17th as an indicator to suggest that we will experience a renewed sustainable rally. 

It appears as if Friday’s volume and the subsequent action, while certainly not by itself predictive of anything fatal to the market, is (currently) pointing toward a rebound rally but not the start of anything sustainable.  But there certainly seems that the odds favor a rebound rally – typically those last from 2-7 days.

However, should the market again turn lower it should not necessarily be interpreted as a signal that we will again see new intermediate lows in stock prices.  A positive for the market could be a pullback (a retest, if you will) of recent lows (about 1,370 points on the S&P 500) on light volume followed by one (but preferably two) 9-to-1 upside days.

But I do take note that we are entering a seasonably difficult time period for the stock market.  That, combined with confused indicators, is keeping me from pulling the “buy” trigger without more solid, confident evidence.

The more prudent strategy for cash (read: a better way to lean toward capital preservation) would be to either wait for a second (non-dirty) big upday, and/or to watch for broad and persistent demand before buying.

And for the record, I am not only looking for 9-to-1 days.  There are certainly other indicators I follow, including some very important ones the have in the previous sixty-years been accurate in identifying major market bottoms. Some of these do not affirm the bullish connotations of the VIX or of the UBS Risk Index as the market being oversold enough to confidently argue that now is the time to buy stocks.  Without the aforementioned broad demand the probabilities lean toward a tough stock market in September and October with us touching lower prices (1,250 points on the S&P 500 would be a reasonable bearish expectation)