Thursday, October 9, 2008

Ugly Thursday - Set up for a reversal?

It might take another day or two but the current decline is very extended and will lead to a sharp rebound to correct the excesses on the downside.

The current market is just like 1987 except that the activity is being spread out over 6 days. It should be over in a day or two with a net 6 day, start to finish loss, of about 23%-25% (900-860 SPX ).

Unlike 1987, traders can get quotes and enter orders, everything seems to be functioning in an orderly manner and that is a big plus. Since orders are being taken, traders are taking shots at picking the low and their stops are being taken out fueling the start of each of the smaller legs of the decline.

Now for a second, let's consider the state of the supply and demand balance. On the demand side the market makers, specialists, short term traders and institutions are absorbing the selling.
* Some of the players will attempt to remain market neutral and unload positions on any tiny rally. This is what is keeping the various issues range-bound most of the trading day.
* Some of the traders are just scalping or trading with a tight stop, they provide liquidity and create froth.
* Some of the buyers are smart short sellers who are covering their earlier shorts, either in size or in pieces. Short covering decreases the float, hence it reduces the supply.
* Some of the buyers are mutual funds with a long term horizon, they are effectively removing supply from the market as they intend to hold the stock for more than a few days.

On the sell side:
* Institutions, ETF's, mutual funds, and individuals are liquidating positions and moving into cash. Their selling reduces the supply since most of it goes into strong hands.
* The churn, or all the daily trades caused by stop loss orders, forced margin liquidation scalping and other short term activities. This is primarily noise but adds liquidity.
* Late comers to the short side, especially the effects caused by hedges using ETF's or put options or futures, along with new shorts. The ETF's, short funds and options events are translated into the cash markets as sales. All of these trades represent latent buying power.

As the market declines, panicked sellers are removed from the supply side of the book as in the aggregate, the stock moves from a pessimistic holder into the hands of an optimistic holder.

When the move is extended over several days, each new low flushes out more of the weak holders who decide to throw in the towel and sell. As the market decline reaches fever pitch it becomes front page news, fueling the fear and inflaming the decline. This is about where we are at the moment. `

Now, at some point the world economic powers decide that this is one "free market" too many and that they will need to intervene. Doubters need only realize that, if they want to, the government can print enough money to buy all the stock being offered. In practice this will not be necessary, but it is possible.

Further, we should realize that the people in the government making these decisions are aware of the various methods for determining where a market is in its buy-sell cycle. In extreme conditions like we are experiencing they should know that all the indicators will deviate from the prior normal ranges and make new extremes. They should also be able to sense when the markets selling pressure is exhausting itself. Then when the rubber band is stretched out as far as it will go, they will act. This is exactly what happened in the days following 911.

If there is some sort of buy side ignition, we must remember that the "overhead supply" has been significantly reduced. When the market starts to rally the bargain hunters will jump in along with the shorts covering.

Remember, it was only 900 mostly banking stocks which had short restrictions. Further, there will be a massive unwinding of short side ETF's which will be translated into a market which has no available supply. Prices will skyrocket and unlike previous one day wonders, I believe the rally to come may go straight up with no significant corrections for the first few days. It's not a prediction,. but something to watch out for.

SPX Daily with some arbitrary trendlines.

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