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At Home on the Range


Don't you just LOVE the winter?!

In December I wrote something about the frequency of swift, sharp pullbacks in the Nasdaq 100 during the month of January. It was unusual for us to not see that index pull back at least 5% within a 10-day window during the month. We nearly reached that mark once again this year, so it's a good time to see if this may be about it for the decline or whether it's more likely the start of something bigger and badder.

There is some evidence of excessive pessimism out there, which is really quite remarkable given how short the decline has been. For instance, so far this year odd lot short sales have recorded 6 of the top 10 readings since 1970. These are bets placed on a market decline that are executed for fewer than 100 shares at a time and is a contrary indicator (i.e. when they are high, it is normally a good sign for the market). While there is always the possibility that there is something "funny" going on with the data, this reflection of small-trader pessimism has been an excellent buy signal over the past few years.

Likewise, traders in the Rydex family of mutual funds have been more than 5 times more likely to invest in a "safe", low-beta fund at Rydex rather than a "risky", high-beta fund there. This type of risk-aversion was last seen in March 2004.

There is something else intriguing, and that is the pattern of the market itself. Since 1950, there have been 7 other years where the S&P had slipped at least 2% within a 5-day period while still in an uptrend in January, after previously hitting a new 52-week high sometime in the previous 10 days. This could reflect tax-related selling that some are suggesting is the cause for this year's malaise. In those 7 other years, the S&P 500 was higher 30 days later 6 times, with an average return of 3.5% (the lone loss was a meager 0.8%). So if, indeed, tax selling is behind the recent declines, history suggests it should be short-lived and we will soon be taken to new highs.

There is some relatively solid evidence that what we are seeing now is only temporary. However, I'm having a hard time fully buying into that outlook. We saw truly excessive risk-taking in late December, and that type of activity isn't worn off in just a few days.

Looking at a broad gauge of our indicators, whenever we have come off a similar extreme since the bull began in 2003, what we have seen each time is a two-month-long trading range, where the S&P has been trapped within about a 5% range from high to low. I suspect we will see something similar now - breakdowns will not travel too far before buyers step in, and rallies approaching the December highs will have sellers licking their chops. Not advice of course, but I'm looking to rely more on oscillating, overbought/oversold type indicators now as opposed to trying to hop on trend-following strategies.
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