Hopeful bulls get kicked in the gut

S&P500 daily at end of day

Stocks had a bad day and the selling is not done yet.  Lower prices are in our future, but we’ll see a couple false bottoms along the way.  Each of those rallies will be selling opportunities.  But at the same time, don’t get greedy on the short side and be prepared to take profits soon because this is just a pullback and not a crash.

MARKET BEHAVIOR

Stating the obvious here, but the markets had a bad day.  Friday’s weakness is continuing after a brief pause Tuesday.  We clearly shattered support at 1430 and sliced through the 50dma.  Volume is higher, but not off the charts.  No doubt this is putting fear into hopeful bulls and making them question themselves, but so far there has not been a mad rush for the exits on tremendous volume.  Technically we’re resting in the upper end of August’s consolidation.  Will this provide support or are we going to break 1400 and possibly test the 200dma?

Clearly downside volatility is back in the markets and shaking up the complacency that was creeping in.  Is today enough of a shakeup?  Or will this thing go longer and lower than most expect?  And of course we have to watch for a multi-leg move lower with sucker’s rallies along the way.

It looks like the uptrend has been broken and we are seeing lower-highs and lower-lows.  There is no big news story shaking up the market, just demand drying up and prices falling without new buyers left to prop up the market.  Will bottom-pickers come in and prop up the market again, or do we need to fall far enough to tempt value buyers with irresistible discounts?

MARKET SENTIMENT

This decline has clearly rattled bulls, but has it shaken them out?  Are they selling by the fistful, or desperately holding and hoping for a bounce?   We need to shake the tree and see climax selling before this will exhaust itself and reverse.  Was today that day?  Or will the lower selling volume subject us to a multi-step decline with bottom-pickers trying unsuccessfully to prop up the market?

Markets top on complacency and bottom on irrational fear.  We had complacency and that lead to this pullback, but have we hit irrational fear yet?  By that measure, I think we still have a way to go before this thing bottoms.  I’m not predicting a crash like we saw in 2008 or even this summer, but we do need to put fear back in the markets in order to create fuel for the next rally leg.  Markets rally in the face of fear and decline on the back of hope.  We have a way to go before all that hope is replaced by fear.

The reason these contrarian trades work is basic supply and demand.  People trade their outlook and when they are bullish, they are fully invested.  But when everyone is bullish, that also means everyone is fully invested and there is no one left to buy and continue pushing prices higher.  At that point prices fall due to a lack of demand.  And on the opposite side, when everyone is most fearful, everyone has already sold and supply dries up.  Tight supply means rising prices and that is what causes the bounce.  Bringing that insight to this analysis, we are looking for everyone to sell before we can bounce back.

The above is an intermediate-term outlook, but in the more micro view I expect we’ll see multiple bull-trap rallies along the way that suck in aggressive bottom-pickers and tempt nervous bulls to continue holding.  That will temporally increase demand and tighten supply, pushing prices higher in a relief rally.  But these are short-lived phenomena and after a day or two the decline will resume.  We will keep sliding until most of the sellers are flushed out and value investors see such fantastic discounts they won’t be able to resist buying stocks by the truckload.

TRADING OPPORTUNITIES

The trend is clearly lower with the market making a series lower-lows and lower-highs.  It is best to trade the trend, so be extremely careful with any buying and be ready to harvest any long profits early and often.  This is one of the few times when it makes sense to short the market.  We’ll probably see a stair-step pattern lower with false bottoms along the way.  Sell the rallies and buy the dips.  We’ll probably push lower and test 1400 and the 200dma over the next few weeks.  But remember the market sells off far more quickly and we’ll find the bottom soon.  Don’t get greedy and be ready to take your short profits soon.

The election is a huge psychological milestone and that could trigger a reversal in the markets.  Obama leading in the polls could make for a soft market, but expect an Obama win to send the markets higher.  This isn’t a referendum on an Obama presidency, but the markets habit of selling the rumor and buying the news.  An Obama win will already be priced in the market by election night and it will be ancient history as far as the market is concerned before the votes are even tallied.

Stay safe