Securities Research Services

Tuesday, September 16, 2008

Regression Theory and Key Reversal Days

If you return to our May, 2008 archives you will note that we indicated during that month that short risk was low. Our reasoning was based on the fact that the SPY had rallied up to its 200-day average, an area which coincided with the bear market downtrend. We advised shorting strength in this area.

Indeed, the market declined more than 15% from the May top and shorting strength in the early May rally proved to be the most profitable position to take.



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Now that the market has experienced a multi month decline from its May top the risk situation has reversed. Note that over the past month we have indicated that risk on the short side has increased even as short positions have been paying off well. The increase in risk can be measured objectively based on the relation to the weekly B-Band and the 50-week average.

Today the SPY tagged the lower weekly B-Band.

Also recall an interesting characteristic of bear markets wherein prices tend to regress to their mean, which we outlined in February. The mean that bear markets tend to regress to is their 50-week averages. As of today’s close the 50-week average is at $133.60, or more than 8% above today’s closing price.

Moreover, note that $117 represents support at the SPY’s 20-year trendline.

The market’s downtrend is still in tact and the road is bound to remain bumpy for some weeks to come. But, what has changed since May highs is the fact that the SPY is oversold, it is at an area where support is very likely to be found, and volume at today’s $117 test was the type of volume that can be expected at key reversal points.

In other words, shorting at these levels offers too much risk to manage and traders should begin looking for buying opportunities into dips.

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