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September 15, 2008

Base Position

And today, ladies and gentlemen, demonstrates why I maintained a base short position. As has been stated here repeatedly, in bear markets the surprises are to the downside. Today's downside was a slaughter. The S&P 500 shed nearly 5%. The Banking Index was hit for 8.4%. The Dow and SPX both set record volumes for a single day with the Dow trading 2.2 billion shares. That's 30 stocks, 2.2 billion shares. Amazing.

What's even more amazing is that the current mess started exactly when the Banking Index tagged 75. One could have written a script for this and then gone on vacation: If $BKX = 75 the sell everything.

index chart

Yesterday, I posted this chart for you as speculation of what would happen if Lehman were forced to file for bankruptcy:

stock chart

Here is what actually happened:

index chart

So the big question is: was that it? Have we reached a level of panic selling that will mark an intermediate-term bottom? Let's have a look at a few of our favorite indicators and make a judgment.

indicator chart

indicator chart

indicator chart

With the exception of the VIX, nothing seems to be indicating panic at this point. I would prefer to see a confluence of extreme readings in order to get chased out of my shorts. That is not to say we won't get some strength in the next few days. Even if we are heading lower, it would be reasonable to expect some consolidation of today's impulsive move. And I do believe we're heading lower. Elliott Wave analysis puts us in wave 3 of 3 in this bear, and being the middle wave of the entire bear, it is likely to take sentiment readings to new extremes. Also, as measured by wave 1 of 3, the current wave should extend price down to 1080 on the SPX! So for the time being, I'm staying short.

Another surprise delivered in today's session was the $7.50 drop in the price of crude oil. People who tried to catch a bounce off $100, including yours truly, got a left hook to the noggin. Remember paragraph one, sentence two? In bear markets the surprises are to the downside. For this reason I kept my risk limited by playing for a bounce with an OTM call option. My loss was minimal, and I'll probably try again when oil hits $85.

Now, a lot of bears are fretting about what the Fed will do tomorrow. I'm going to suggest you not worry about it, and here's why: the bald guys are trying to show they can be tough. Paulson and Bernanke quite fervently stated that taxpayer money would not be used to bail out Lehman, and they held their line. I think one of the reasons a deal was not settled is because all the potential buyers thought these guys were bluffing and were holding out on offers until the government folded and ponied up some dough. Didn't happen.

To cut rates tomorrow would immediately debunk the tough guy images the baldies have just manufactured. I don't expect a rate cut tomorrow, and even if we do see one, I would use the pop to press my shorts. Each cut over the past 14 months has produced a fizzle, and the fizzle keeps coming faster. I think Bernanke knows this, which is why he won't cut. He will cut next when it will gain him some political favors.

That said, I bought some silver as a hedge. I chose silver rather than simply buying OTM calls against my SPX shorts because the metals appear ready for a bounce, so this position has a dual purpose. Besides, the main threat I see to my shorts at the moment is an excessive rate cut, and what better asset to own in that situation?

Told you this week would be a thriller.


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