Thursday Thump – Is There A Bottom?

The market has a lot of work to do to test our bottoms today.

The Dow has 788 points to fall before retesting 7,731, the S&P is 57 points above 896, the Nasdaq is 73 points away from 1,542,  the NYSE only needs 294 points to hit 5,336 and the Russell is 34 short points away from 467.  These are all spikes down that were hit on October 10th and all are a bad day's move away in this volatile market.  The 33% rise in the VIX yesterday indicates a violent move may be coming, as did the wedge we observed in the S&P in yesterday's post. 

Last night, Tom2oc noted a similar wedge in the IWM, the ETF that tracks the Russell, as it squeezes into a range that may lead up to a violent move, one way or the other.  On the whole, it would be preferable to get what Pink Floyd calls "a short, sharp shock" of early selling to give us a bottom today (like last Thursday) rather than a drift lower into the weekend:

Despite the carnage, we took a shot on a March Russell spread yesterday as the almost 200-point drop (25%) in 30 days makes for some attractive risk/reward profiles on that index so it was a good time to take advantage of the once-again crazy front-month premiums to give us a cheap entry on the leap.  Should the small caps be over 40% off their highs of last year?  Has Main Street been so devastated by Wall Street that we have erased 5 years worth of corporate growth?  The last 3 months we had drops this severe (actually this is 100% worse) in the Russell were August 1998, Sept 2001, and July 2002 and all three times it marked a bottom with quick reversals on the first two but 9 months of consolidation in 2002. 

The good news is – WE'RE FINE WITH CONSOLIDATION!  We know lots of ways to make money in a flat market so bring it on.  It will be great to get off this hamster wheel of a market and make a few plays that stick for more than a couple of days.  There are tremendous opportunities out there but we MUST hold up here, at about the mid-point of the 2000-2002 trading range.  If we break down below here, we are almost certain to head down to 50% and 60% off our highs and, as Asia is proving this morning – even that may not be enough to satisfy the bears!

The chart above is a good illustration of the market cycle and the factors that go into it.  The trick is to identify if we are far enough along in the Bear Market to see company fundamentals improving (but ignored) or attractive fundamentals.  As we are still rife with economic uncertainty, it's hard to call the fundamentals attractive and yesterday the testimony of the ratings agencies to Congress did not inspire any investor confidence as it became apparent what a scam the entire mortgage industry was running in this country.  The same lunacy that drove money into housing and formed that bubble also drove money into commodities and formed that bubble and then into equities, forming what we now have to call a bubble there in October of last year. 

The financials and the builders have dropped over 50% in the past year while energy (XLE) is "just" off 35%, along with the Dow at the moment.  If you expand this chart to 2 years, however, you will see that the XHB (homebuilder index) is off 70% overall with the financials still over 50% and the Dow and the XLE "only" off 20%.  Keep in mind that the energy sector went from holding the markets up for the first half of this year to leading them lower in the second half – a real shame as CVX was added to the Dow, which weighted that index much more to energy than it had been (and adding financial disaster BAC wasn't exactly a booster either!).

So, we have a LONG way to fall if we break below our lows.  David Fry illustrates that in his morning post and we need to take Tom's lower wedge of the IWM VERY seriously.  That means we need to see daily IMPROVEMENT without breaking below 50 if we are to hold it together between now and expiration.  Next week we will need to hold 51, then 52 and we need to be at 54 or better for expiration day otherwise it will be a very suspicious "recovery."  The Russell is diverse enough with market caps small enough to give us a better indication of whether we are getting bargain hunting or abandonment in the broader market so we're going to be watching them like a hawk for the next few weeks.

Our Ultra-short bets (including the ones we added in the morning post) were huge winners yesterday (as were the XOM puts) as we blew our 40% levels yesterday in all but the Dow and we blew our must hold levels on all the indexes but the transports (who are benefiting somewhat from cheap oil) and BOTH need to be taken back before we even consider a bullish play but JPM has a good list of companies worth considering, including MMM, GOOG, HPQ, MCD, MRK, PM and V and I'll be putting up plays for all of them in member chat as the sale continues.  Taking the ultra-short hedges, which gained 30-40% yesterday alone, is a great way to give yourself some cash to do a little bottom fishing on the way down.

Asia continues to be a catastrophe with the Nikkei dropping another 2.5%, led down by SNE cutting their outlook in half while the Hang Seng dropped 3.5% to 13,760, a full 57% off their highs.  Shanghai held the 67% off line at 194 and the overall Dow Jones World Index made a fresh low at 166, about 48% off the top.  Over in Europe this morning (9 am) things are just as pathetic with the Dax leading the way down over 4% with the FTSE and the CAC both at the 2.5% rule ahead of the US open.  Sweden made a surprise half-point rate cut while Hungary is the first country to break down and raise rates (3%) in order to stop investors from fleeing the country.  This is VERY SIGNIFICANT as it is step one of the inflationary spiral that threatens to engulf the planet – despite gold dropping to $700 this morning.  To attract capital, banks AND, ultimately, governments must provide an adequate return on risk.  Right now the dollar is benefiting from a "flight to quality" but, over time, investors will be evaluating the return on their capital more conservatively (right now they are just happy to get it back) and will be demanding rates that reflect the risk of holding dollar assets over time.

We're going to go with the flow and watch our levels, we'd love a good reason to pick up QLDs at $30 and they are worth a shot as long as they hold $29 (they were $43 on the 14th.  Tech earnings are simply not that bad and, if we are going to get leadership, it should come from the Nasdaq.  I also like AMZN at $43 and RIMM has certainly suffered enough at $49 so, as long as we hold our index levels, we can take a chance with the stocks ahead of the covered call play or just buy the covers as momentum trades:

It would be better to get the short, sharp shock down to give traders the capitulation event they are waiting for.  We have to be very suspicious of any rally that doesn't give us back our 40% levels AT LEAST!  In all but the Dow and the Russell, a 5% gain on the day is not even enough to get us over the 40% line – that is truly pathetic…