Sunday, March 16, 2008

The Panic of 2008

Panic: A sudden widespread fear concerning financial affairs leading to credit contraction and widespread sale of securities at depressed prices in an effort to acquire cash.

What we are seeing in the financial markets is historic, the bankers have fucked up big time and the devil is demanding his pound of flesh. What we have is a full fledged Banking Panic where the supposed "professionals" are acting irrationally as they run for the exits.

The key word here is irrational. In my opinion, the Fed made the right move by making credit available to institutions like Morgan this week. I think a lot of people are caught up in the rhetoric of what is occurring, as if the entire system is going to collapse. This is nonsense but the danger exists that in a panic to escape something they don’t understand, and that may in fact be less severe that what is perceived, professionals are acting irrationally and running for the doors. Bail first and ask questions later. This type of behavior is what causes long tailed spikes in the stock market and something similar is happening in the banking industry right now. By the time this is over, I think it will be realized that the doubted collateral did in fact have value, maybe a little less than face value, but a lot more than is being currently ascribed to it.

But, I don’t trade bonds, so what does this mean for the stock market? One has to question how much of the downward pressure in the stock indices is a result of liquefying collateral assets, and how much is a result of the slowing economic conditions.

I believe that since the majority of the negative economic news is coming from the financial sector one has to at least consider the possibility of a wipe-out on the downside. The markets are behaving irrationally at the present moment, this means that within the monolithic block of equities we call the market, there are stellar opportunities to find value.

Taking stock. Again the keyword here is "irrational." The players in the markets are being over emotional, traders are nervous, and the price movements are highly volatile.

The Risk:

The first point I would make is that one should never discount how irrational the markets can be in a panic situation. Concepts like "value" get thrown to the wind as panic investors turn equities into cash. Just because something "looks cheap" doesn’t mean it can’t get cheaper. If the markets break sharply to the downside in the next few days, it is entirely possible for them to decline another 15% from present levels.

The Possibilities:

Market internals, the technicals, are in the general ranges found at bottoms and we can use them to evaluate where we are in this train wreck.

1. The McClellan Oscillator is forming a zigzag bottoming pattern. This could be over in a day, or in a week, so it bears watching. Additionally, the 10% Index is indicating that whatever bottoming process begins here will be re-tested within the next ten weeks or so.

2. If the markets continue falling next week, then the McClellan Summation index will fall below –1000, While this is in the zone where bottoms form, it also is accompanied by accelerated declines in equity prices.

3. The AAII sentiment numbers indicate 60% of the advisors are bearish, this is the type of reading which is necessary for capitulation on the downside in order to start a new bull run. Again, this could persist for a bit longer but taken as one of the best contrary indicators, investor sentiment is Bullish.

4. The other technical indicators, New Highs vs. New Lows are not confirming the decline. This is bullish.

5. The price indicators, MACD’s etc on the major indexes are within 3-4 days of turning up. The price turn happens before the indicator’s change direction, so this is moderately supportive.

6. Aside from the problems in the Housing and Financial sectors, the fundamentals are only moderately negative. There is evidence that the economy is slowing but according to the UCLA economists it will not enter a recession. Corporate balance sheets are reasonably strong and relatively speaking, stock prices are cheap, so there is justification for thinking the market is going to go higher for a couple of years. It will take another six months to get people interested in stocks again, I suspect in the period between now and the election, we will have choppy, essentially trendless, action and the real rally won’t start until after the election once the banking mess is cleared up.

What I’m Watching For:

1. Some evidence that the market is turning higher. I expect that the upcoming earnings reports from the financial sector will continue to be negative. IF, the stocks rally on this bad news it is bullish, anything else is a non event.

2. In any decline a $TRIN reading over about 4 would be a reversal warning. The TRIN compares up-down stocks to up-down volume, one is a neutral reading and increasing positive numbers indicate increasing fear (selling pressure)

3. I’ll watch the VIX (Volatility Index) whatever it does, except for going to 10, is a buy signal here, fear is rampant. At the moment, volatility is very high, this works both ways and eventually dampens down. It is the reason the VIX is high, the VIX is telling us how big each stick is. When the market is trending in an orderly manner (up or down) the VIX will be lower, and the daily sticks will be shorter. At points of volatility, blowoffs either up or down, the daily sticks will be long like they are now, and the VIX will be higher.

4. An up day with Up Volume 10x Down Volume. As I noted in an earlier post, we have had several down days with lopsided Down to Up Volume ratios and what we need to see to confirm any upward trend is two 10 to 1 Up Volume days within sighting distance of one another.

5. Stocks which do not break their previous lows on any upcoming decline. Now is not the time to be a hero and pick the "exact" bottom, leave it for someone else and buy a lottery ticket. Since the bottoming process will take a few months, stocks which take out their prior lows are not finished scaring people yet, buy something else.

Watch for a cycle low Tuesday 3/18 in the first hour of trading.

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