It's Time to Play for a Snapback Rally

Depending what index you look at, this market is down as much as the 1929 crash at its lows. Think about that for a second. The 1929 crash has always been the anomaly in the data set, the disaster that could never happen in our lifetime ... and here we are, living through it.

The market rallied 50% off of the lows in 1929 before going on to a 90% overall decline for the equity markets, which ended in 1932. If we assume we are in a 1929 scenario and use this as a template, the market is currently oversold by those standards. The market is clearly broken, but this may be a spot to continue to pick up small positions in a couple of names and look for a countertrend snapback rally.

We have made several attempts to "probe" this market in the last two months. Any attempts on the long side have been stopped out as the indices have redefined the definition of "oversold." Nonetheless, we'll give you a couple of statistics on just how extended this market is.

S&P 200-Day Spread

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On Thursday the spread between the S&P 500 and the 200-day moving average reached 40%. The spread on the equal-weighted S&P 500 index reached 44%. Numbers like this were only seen in the 1930s; the max reading was 49% in 1931. A 49% spread would put the S&P 500 at 625, by our calculations.

We're not saying that the market can't blow through these numbers and set new records, but the 1930s was the period of greatest stress in market history, and it wasn't much worse than what we are currently seeing.

We're also seeing some bullish momentum divergences in this market. In a period of real stress these divergences don't mean a lot, but it is interesting to see that the 21-day rate-of-change indicator has diverged here as the market makes significant new lows. This is confirmed by all of our short-term momentum indicators. We're also seeing a divergence in the percentage of stocks more than 2 standard deviations below their 40-day moving averages. This indicator reached 56% yesterday, but it registered a 95% reading Oct. 10. Deleveraging and panic at the institutional level is calling the shots in this market. The move of more than 7 points in 30-year Treasury bonds Thursday tells you everything you need to know about sentiment.

S&P Secular Trend Line

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One way to play for a potential countertrend rally is to skip individual names and go for a leveraged ETF. The ProShares Ultra S&P500 (SSO - commentary - Cramer's Take) is levered at 2 times the S&P 500.

There is a rising secular trend line in the S&P 500 at 727. Considering the historic oversold nature of the market and the extreme spread to the 200-day moving average, we believe if a countertrend rally is going to develop, it has a good chance of doing so after a retest of this support line. A test and reversal will trigger a buy signal.

If you're going to take shots on the long side in this environment, the most important thing is a stop-loss put order entered at the same time as the buy. We would place a stop at the low for a reversal bar off of the 727 levels.

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At the time of publication, John Hughes and Scott Maragioglio had a position in SSO. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.