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September 29, 2008

From Bailout to Fallout

The tough part about producing a blog post after today's session is figuring out where to begin. We basically witnessed a mini-crash with the S&P 500 down 8.8% and the Nasdaq 100 down 10.5%. Apparently no one imagined that Congress would reject the bailout bill. But I think there is more to today's selling than simple disappointment over government handouts. The world was also surprised to learn that, despite centralized efforts, more banks are in need of rescue on both sides of the pond. In addition, I suspect a lot of liquidation was related to end-of-quarter activity.

As evidence to this last postulation, witness that silver slid 30c even while gold was up $25. Many funds use silver as a way to spike returns since it tends to experience greater swings. Silver is more volatile due to the fact that it is a thinner market. However, this characteristic works in both directions, and the best explanation I can devise for the divergence in the PMs is that funds were being forced to raise cash, and hence silver, being a thin market, was subjected to a lot of pressure as positions were unwound. It is also possible that many funds were long silver and short gold as a way to be bullish on the silver/gold price ratio. Unwinding of these positions would also spike the PMs in opposite directions.

In my weekend post, I suggested that the NDX would visit 1450 before this selling wave terminated. I certainly did not suspect that it would cover most of that ground in one day, but as it stands, the NDX is within 50 points of the target. Previous posts have also outlined my interpretation of the Elliott Wave picture for the SPX and suggested a target of 1080 for the wave 3 of 3 decline. As of the close, we are within 30 points of the target.

index chart

The VIX is showing extreme panic, boasting a high of 48 today. The last time the VIX saw these levels was... can you guess? Not during the 2001-2 bear, but rather all the way back in 1998 during the LTCM crisis. However, just because the VIX is showing a multi-year extreme does not mean we have seen the bottom. After all, we also saw a multi-year extreme reading last week. I would like to see other indicators showing coincident panic. So let's have a look.

indicator chart

indicator chart

indicator chart

indicator chart

As we can see, the shorter-term indicators are showing extreme panic whereas the intermediate-term indicators have not yet lurched into panic territory. Here is how I see things unfolding: sometime in the near future... perhaps tomorrow, perhaps several days from now... the SPX and NDX will make thrusts down to the targets described above. These thrusts will end wave 3 of 3 of the bear. A quick wave 4 of 3 will develop as a countertrend rally, followed by another thrust down to test the target lows. This final test... which will count as wave 5 of 3... will see the intermediate indicators pop into panic territory, thus setting up a larger Wave 4 rally that could take us through the end of the year.

There are two more indicators supporting this thesis:

indicator chart

indicator chart

I would expect these averages to diverge positively with the wave 5 of 3 test of the lows.

It's eery how the news sometimes seems to conform to what the market is otherwise setting up to do. The 3-day rally into the end of last week looks nearly identical to a 3-day rally that ended two weeks prior, and the result was the same: a massive sell-off. So a chart reader could have guessed we'd see a big sell-off without even being aware of the contemporary news. Along those lines, I suspect some bullish news will coincide with the end of wave 5 of 3, such as an interest rate cut or, if it doesn't happen sooner, the passage of a bailout package.

The big question is how to game all this action. I began by trimming my shorts today, and I will eliminate the rest of them if and when the SPX hits 1080. I really do not think the market will simply collapse further here. Historically, the odds are highly against such an event, and if we do crash from such oversold levels, I will become more concerned about personal survival than how much money I make because I would interpret such a crash as deathly ominous.

While preparing to pare shorts, the next question on traders' minds should be what to get long as the market sets up for a bigger countertrend rally. Precious metals miners are certainly a reasonable choice as they remain in a secular bull market, and seem to have exhausted their correction.

stock chart

I'm going to bounce something else off all you traders. With all this panic going on, if one is thinking of getting long some asset class, get long China.

china chart

I firmly believe that China will lead the world out of its current recession, and I want to own a piece of their market before it happens. If we can get a successful test of the recent low in Chinese stocks, I'd be inclined to allocate some capital there. I bounced this idea of a friend who manages money... and who also happens to be Chinese, FWIW... and asked him what he thought of the China ETFs. He instead directed me to the Matthews China Fund as a more astutely managed alternative. I've only glanced at the details in a cursory manner, but they have outperformed their reference index on most timeframes.

Whew! That was a long post. We are certainly not cursed with uninteresting times!


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