3 Handed Strategist

You’ve heard about the two-handed economist? How about a three-handed Strategist!

Last week, the market exhibited additional signs of attempting a reversal. On Tuesday and Wednesday, major indices opened down strongly, only to close at or near the highs of the day. This typically indicates that weak hands are being shaken out of long positions.

This week started with a strong rally on moderate volume. Oil worries started to ease, the Olympics opened without incident, and improving economic news support the Fed view that the past few months might just have been a soft patch.

As we have noted on the past, bottoming is a process, not a single point. As of right now, we see 3 potential scenarios playing out as the markets move towards the 4th quarter:

Scenario 1: Waterfall declines leading to a much lower low: In our opinion, this is the least likely of the 3 possibilities. Internals have been relatively good. Market breadth, despite the serious pullback since the January highs, reveals accumulation actually continuing by large institutions. This is not the sort of environment that typically sets up a catastrophic sell off – at least not without some externality.

Scenario 2: Rally for the rest of the year: In order for last week’s lows to be the bottom for the year, several factors must come together at once: Volume needs to come back into the market in a big way; Oil needs to decline 3-$5/bl sooner rather than later; Economic reports need to show continuing signs of strengthening – or at least to stop decaying; Lastly, the markets need to have a follow-through day (a/k/a William O’Neill confirmation day), with a rally of 1% or better on higher volume than the previous day, on the 4th to 9th day after the initial move up. That’s somewhere between Thursdays 8/19 to 8/26. A confirmation day would show that yesterday’s rally was not merely a “one day wonder.”

Scenario 3: New Lows in September-October: The last scenario is what happens if scenario 2 fails to occur – i.e., we fail to get a confirmation. The market meanders here, near the lows of the prior trading ranges: 9,950 on the Dow, 1082 on the SPX. Nasdaq continues to kiss the underside of the prior range up to 1850. But perhaps nothing is able to move indices decisively through this barrier. That leads to a new low for the year in the dreaded September-October period. This sets up a Q4 election year rally, straight into January.

It would certainly help scenarios 2 or 3 a great deal if we can get through the next 3 months without a major incident of terrorism, particularly domestic terror.