What Yesterday's Partial Gap Fill Suggested

The market is gapping up large this morning so I feel a little silly discussing how yesterday's action suggests good things for the next few days.  Still, I did not note anything bearish  about yesterday so I thought I would show one of the studies that I found compelling that appeared in the Quantifinder as we approached the close.

There have typically been 1-2 days of buying following such setups.  It will be interesting to see if the upside edge exhausts itself early here or whether bulls can follow through and add to this mornings gains over the next day or so.

September Performance After Bad Augusts

September has a well-earned reputation as the worst month of the year for the stock market. Last night both Woodshedder and Michael Stokes provided nice historical breakdowns of September. For the 2nd year in a row the market has suffered a difficult August with the SPX closing down about 5.6%. This left me to wonder how September has performed following bad Augusts. Below I have compiled a list of all Septembers after August lost 4% or more.

There doesn’t appear to be a strong directional edge, but one thing that is evident in all of these Septembers is that there was high volatility. The 1966 instance saw the smallest range with the market moving a little over 5% from high to low. Six of the eight instances saw ranges of 9.5%+ in September. So I would not look for the action to dull this month.

What the SPX/VIX Action Hinted at on Tuesday

I am seeing some signs that the market is likely to pull back in the next few days.  On Tuesday the SPX closed just slightly higher while the VIX also rose.  This triggered the study below, which I have showed before in the subscriber letter, but never here on the blog.

The reason it only looks at Tuesday, Wednesday, and Thursday is that Monday and Friday VIX prices tend to be affected by weekend time decay in the options market.  Instances are a little low but really could not appear more bearish over the next 2 days.  

Short-term Implications of Breadth on a Follow Through Day

The strong move higher on increased volume meant that Tuesday was a Follow Through Day (FTD). FTDs are a concept that was created by William O’Neil, founder of Investors’ Business Daily. I have written about them extensively on the blog. In June for the 1st time I showed that FTD’s have a better chance of success when they are also accompanied by strong breadth. Tonight I also examined the short-term implications to FTDs with strong breadth vs. FTDs without. This first study below looks at performance following FTDs that came along with an Up Issue % reading that was among the top 5% of all readings over the previous year.

As you can see there appears to be an tendency for the market to continue higher after these strong-breadth FTDs. Now let’s examine performance after FTDs on days that did not show exceptional breadth strength.

Here there appears to be no edge or short-term upside inclination whatsoever. With Tuesday’s FTD coming on breadth that put it in the top 2% of all days for the last year the short-term outlook appears better.

Big Gaps Up After 2 Strong Days of Selling

After 2 hard days of selling the SPY looks to be gapping up strong this morning.  I looked back at other times that the SPY gapped up big after 2 large down days.  Below are the results since 2003 of buying all instances at the open and then selling at the close.

There appears to be a bit of an inclination to follow through on the gap to the upside.  Most of the instances were quite volatile, and all of them pulled back at least 0.4% below the open at some point during the day.  Most of them also took place during 2008 when volatility (both intraday and overnight) was elevated.

A Post-QE2 POMO Indicator Update

I haven’t shown an updated POMO chart on the blog in a while, and with QE2 now in the rearview mirror for the calculations I thought readers might find it interesting.

POMO stands for Permanent Open Market Operations and it is how the Fed goes into the open market to buy securities. The net effect of this buying is an influx of cash into the system. It appears a portion of that cash makes its way to the stock market and works as a bullish influence. A “POMO Day” is simply a day where these operations take place. The chart below shows my POMO Volume indicator. The top pane is the S&P 500. The bottom pane is the total amount of money infused into the system (POMO buying) over the previous 20 days.

The obvious takeaway here is that periods of heightened POMO buying have led to strong stock market rallies. Periods of weak or negative stimulus have been followed by market drops. This chart only goes back to 2008. For a longer view back to 2005 you may use the link below.

http://quantifiableedges.blogspot.com/2011/05/long-term-look-at-pomo-stock-market.html

Looking at the far right side of the chart you can see POMO volume has dipped substantially since the end of QE2 (end of June). It has now reached a level where it is expected to be maintained for the foreseeable future. In the past when POMO stimulus ended – it ended. This time the end of QE2 has led to a period of substantially less stimulus, rather than none. This made it tricky in determining whether the end of QE2 would be followed by a sharp market drop. (It was.) While there IS still liquidity pumping going on, it appears the reduced level is akin to providing a heroin addict a couple of aspirin to try and get high.

The link below shows the POMO activity schedule on the Fed’s website.

http://www.newyorkfed.org/markets/tot_operation_schedule.html

If you click it you will notice there is a tab on the page where you can see “All Schedules” rather than just the “Current Schedule”. Clicking that tab you will see that the monthly estimate of POMO activity for last month and this month is about $14 billion. During QE2 the level was normally around $100 billion/month. So is the market capable of mounting a serious new bull move with the modest amount of stimulus currently being provided? So far I have seen no evidence of that, but I suspect it could if it starts from a “low enough” level…

Large Gaps Down After 3 Up Days

This volatility continues this morning with a big gap down.  The study below shows performance for the day following large gaps that occur after 3 consecutive up days.

These stats do not appear encouraging for the bulls.  Below I have listed all instances.

This view isn't any better.  It appears there is some potential for another ugly day. I'd use caution buying today.