The distinct possibility of a crash

Technical trading is a game of probabilities involving indicators, patterns and history. There are times, like near the peak last month, when the odds of a certain outcome are very high, since you have so many indicators in positions that have been followed by the same outcome. There are other times, like right now, when you don’t have strong odds of any particular outcome, but you do have a higher than usual chance of a rare outcome: in this case, a violent resumption of the deflation trade from relatively oversold conditions. A hard decline from oversold conditions can lead to panic, since it feels like the market “just isn’t going to stop falling.”

I still very much like the summer 2007 analogue, since this winter, as then, the market fell hard off of a very long and calm stretch of gains on low volatility and extreme complacency (the “Goldilocks era”). What I see now is a market that, with yesterday’s rally to 1080 and this week’s little ramp in DSI bullishness, has corrected its oversold condition just enough to resume the decline. Stock bullishness now has 20% or so of downside to go before reaching the level seen at the bottom of declines of this nature (hard first plunges from long periods of complacency: May-June 2006, Feb-March 2007, July-August 2007, Oct-Nov 2007).

The VIX has the room to spare, as does the put:call ratio. I see in early trading this morning that several markets are showing weakness as they approach support. It is still possible that they bounce and we charge ahead towards 1100 and beyond, but I would not count on it. Like I said a few days ago, and Daneric actually mentioned last night, perhaps this decline resembles the start of wave 3 of primary 1 (May-July 2008), a stair-step process of small rallies just big enough to keep people guessing, followed by new lows.

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I’ll be away from the markets for the next few hours, unfortunately, but I have sell-limit orders in place for the above possibility. This of course would negate the Euro rally I’ve been considering.

Stock market action bolsters case for a top.

The tide is turning. We now have a strong, impulsive decline off the highs, confirmed by a rise in the dollar and declines in the metals, energy, and grains. Yes, we’ve seen this before (in June, August and September), but the sustained manic conditions (put/call ratio, DSI, etc) that we saw in mid-September and mid-October are unlikely to be revived. When momentum runs out and there are no fundamentals to offer support, stocks can fall under their own weight. They don’t need a catalyst.

The Russell 2000 (like the SPX and Nasdaq) has just busted through its big support line drawn from the March lows to the July lows:

Source: Interactive Brokers

The SPX (S&P 500) has put a toe over the same line, while the Dow has a bit to go. Here’s the SPX:

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Things are looking very bearish intermediate-term, but for the next day or two, I think the odds favor a small bounce. We’ve had two strong weeks of declines, and the overbought, over-bullish condition is cleared for now. I’m long stock futures (and a touch of oil and gold) from today’s lows to hedge my put position. Positioned like this, I get no benefit from further declines, and preserve equity to re-short any rally.

Remember, if this decline resembles that of ’30 or ’37, ALL of this year’s gains could be wiped out in a mere three months. If this is wave 3, it could be much faster than wave 1 (Oct 2007 – March 2009). It marks the start of the worst part of the depression. If you know anyone who owns stocks or is thinking of getting back in, implore them to seek safety (Treasury-only money market funds). Likewise, right now may be the last chance in 20 years to unload real estate at 2003 prices.