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February 3, 2009

A Case For a Sell-Off

Okay, folks. I need you all to play devil's advocate against the case I'm about to make that we are on the brink of another major sell-off. The prospect for going short here looks so juicy as to seem like a trap, so I'd like to hear opposing opinions before I commit to a big play. Here goes.

Let's start at the top with a look at a daily chart of the S&P 500:

stock index chart

As you can see, there are a lot of elements coming together for the bearish case. Apart from the recent price pattern being a nearly identical twin of the days preceding the October crash, we have an aborted assault of the upper triangle bound... typical behavior before a triangle break... along with what appears to be a trend line crawl... also typical pre-break action. As a kicker, the spyders saw $122M worth of selling-into-strength today... not an enormous figure, but certainly worth heeding.

The 10-day moving average of the CBOE put/call ratio also moved closer to the lower bound of its contemporary range, suggesting that equities have a big headwind to a rally if they are not set for an outright drop.

stock market indicator

Some buy programs kicked in around 2:00, sending the SPX up about a percent in a hour. I couldn't resist the urge to fade the move. The more I think about the bullishness betrayed by the CBOE put/call ratio, the less I believe equities can sustain any substantial rally. I expressed this doubt by selling OTM calls on the index. I chose the 875 strike since it represents the most recent rally peak. Pivot points are nice places to write options since they tend to either turn price away or draw price back should the index break through. Both scenarios provide the option writer some extra time to wither away premium. The position size was kept small since I am also considering a direct short.

Another liquidation event would certainly affect commodities, as well, and the CRB seems poised to test 180, the launching point of the entire commodity bull market.

commodity index chart

Our little yellow friend made no attempt to regain the trend line off the 2008 high.

gold chart

I shorted a small amount of GDX near the close. It's a baby step toward an ultimate gold short in size. I've got a tight stop on the play (two, actually... one on the GDX chart and one if gold closes back above the trend line), but if another liquidation event hits, the short could provide a nice bonus.

Alright, I'll make a couple arguments against a sell-off just to get you all going! First, Treasury bonds coughed up most of yesterday's gains. I had expected bonds to rise to keep pressure on equities, but I suppose an inverse correlation is not totally necessary. After all, Treasuries fell during the October crash, and although they spiked into the November swoon, bonds kept rising along with equities into year-end.

Second, the buck coughed up a chunk of recent gains and is threatening to turn its trend downward. I would not expect a big equity sell-off to coincide with a big drop in the dollar. The setup could still resolve higher, but will have to be watched closely.

Hit me.


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