Saturday, February 9, 2008

From the Sentiment Trader Newsletter:

Coming into this week, we were facing a market that had rebounded spectacularly the week before, and optimism about the worst being over was starting to percolate.

As usually happens, though, blind optimism was not warranted. We were still seeing little more than an overbought rally, under resistance, during a bear market. As we discussed last week, that kind of setup has a better tendency to peter out rather than continue higher unabated.

Still, the fact that we saw the "best week in five years" may be something on which longer-term bulls can hang their hat. We looked at a table on Monday that showed other times when the S&P 500 was able to score such a good performance, and it generally led to higher prices the longer out we looked.

Another good sign is simply the huge volatility we've witnessed. At a point earlier this week, 15 out of the past 21 days had seen a move greater than 1%, up or down, in the S&P. We hadn't seen that kind of whipsaw since October 2002.

It's not a coincidence that October 2002 was a time when the market was trying to hammer out a low - we showed a table on Tuesday detailing other times in the history of the S&P that it's been this volatile, and all but (arguably) one coincided with an intermediate-term low.

So we have an interesting sequence here - moderate panic readings in January, then the best week in five years, and now a re-test of those panic lows, all while witnessing an unusually high amount of volatility. All of those signs are pretty classic for a market that is trying to form an intermediate-term bottom, and I have little reason to suspect otherwise for our current situation. This is all in the context of on ongoing bear market, of course, but that does not preclude us from having one- to three-month rallies.

One possible fly in the ointment is that we're seeing relatively few readings of excessive pessimism among the guides we post to the site. Part of that can be explained by the huge panic gap openings from mid-January, and some of the extremes we saw then.

I would much rather we were seeing more signs of concern among traders and would be more comfortable with the idea of a multi-week or multi-month low here if we were, but the other studies we've discussed are intriguing enough to me that I think the worst of the selling is probably behind us (for now).

One good sign is that the latest Commitments of Traders report, released late this afternoon and covering positions as of this past Tuesday, shows that small speculators in the equity index futures have become quite discouraged by recent events.

They reduced their net long position in S&P 500, DJIA and Nasdaq 100 futures contracts by 30% from the prior week, and are currently holding only $8 billion worth of those contracts. That may seem like a lot, but it's the least amount in the modern era - less than any of the major market lows since 2000. From a contrary perspective, that's a positive development.

For the short-term, things seem much more up in the air. Past lows have been very volatile - about three times more so than random - so picking our spots is very important, unless position sizes are kept small. We often see volatile swings both ways, and this week was not an exception. As long as we don't fall and hold below 1310 on the S&P (or 1270 as a last-ditch level), my preference is going to be trading from the long side.

Have a safe and relaxing weekend and we'll see you here next week!

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