ETF Profit Strategies
From bailing out corporations to bailing out countries
Aside from the fact that the world has gone from bailing out corporations to bailing out entire nations, the biggest event since the March 2009 market bottom was the 998-point top-to-bottom selloff on Thursday, May 6, 2010. From 11:26 to 11:46am, the Dow Jones Industrial Average (DJIA) lost 635 points, the swiftest 20-minute decline in history. At one point, the decline erased three months worth of gains – yes, three months worth of gains vaporized in about one hour!
Wall Street was hard-pressed to come up with an explanation for the meltdown. Of course, Greece was the obvious scapegoat, even though we’ve known about Greece’s near-insolvency for over a month. Quickly reports of a clumsy fat-fingered trader who confused a million and a billion popped up in the media. Computerized high frequency trading, communication problems between the exchanges and the lack of circuit breakers were other possible causes dug up within a matter of hours. None of those could be confirmed. In fact, as per a Reuters report, “the top U.S. securities regulator said no single event had been found to explain Thursday’s mysterious market plunge.” I guess that’s why they still consider it “ a mystery.”
Crusin' for a bruisin'
The simple fact is that the market has been cruisin’ for a bruisin’. After nearly three months of not losing more than 1%, the major indexes had become extremely overbought and sentiment extremely optimistic. Protective options buying had all but vanished from Wall Street. The May issue of this newsletter clearly pointed to the dangers of the 0.32 CBOE Equity Put/Call ratio: “The message conveyed by the composite bullishness is unmistakably bearish. The put/call ratio in particular can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses suffered by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only choice is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”
But prices didn’t stay low. The DJIA rallied more than 600 points the same day and managed to record the third-largest gap-up open two days later. The two largest pre-market open gains were scored on September 19, 2008 and October 13, 2008. The September/October 2008 period hosted some of the biggest gains and losses in trading history (see November 2008 newsletter, page 6, “Are big point gains an indicator of major market bottoms?”).
Monday's (5-10-10) trading session added another 405-point bounce to Thursday's rebound. At first glance this seems bullish. But, history tells us it's not. We've found 16 instances where the DJIA rallied 400 points or more, 12 of them hit during the post-2007 decline, most of them in September/October 2008.
This is not an infallible sell sign, and the picture would look somewhat different if you use percentage instead of point declines (most of the biggest percentage declines occurred during the Great Depression and post-2007 decline) but huge rallies are certainly no reason to turn bullish (see charts on page 3).
Regardless of the post-meltdown meltup, the key question is whether Thursday decline was the first installment of the major bear market we've been waiting for?
Unfortunately the question is simpler than the answer. To bring the current situation into context, it might help to look back at some of the parameters we had set previously. The April 2010 newsletter stated that “there are no major resistance levels to speak of until S&P 1,220 and DJIA 11,255 (61.8% Fibonacci retracements).” The 3-24-2010 Market Meter (ETF Pick on EPV) added: “The next longer-term resistance,
and possible the eventual stopping point for this rally, is S&P 1,220. If we get new recovery highs and new sentiment extremes, the stage would be set for a major correction, which would coincide with the worst six months of the year time period.”
The S&P peaked at 1,219.80 on April 26, the DJIA at 11,308 on April 26. Even the percentage of bullish advisors tracked by Investors Intelligence (II) reached a new peak of 56% (highest reading since December 18, 2007 – 56.5%) on May 5, 2010. We've also had plenty of distribution days on heavy trading volume (see chart on page 4). The Thursday selloff fits the bill of a “fast and powerful next leg down.”
As the chart on page 4 shows, all requirements for a major market top have been fullfilled. But are there any flies in the ointment? Yes, as always there are. But there are two safety levels that will help us identify the market's direction.
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