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THE STOCK MARKET TWO WEEKS LATER
Chuck Cohen
May 11, 2010
I. THE FIRST ACT IS OVER

So far the first two weeks of this decline have played out as I hoped, with one exception: the dramatic swoon of last Thursday. I thought that might come, but following one last minor rally.

The media and, as usual this government, has been attempting to finger a convenient culprit for the collapse. But the villain wasn't a person or a computer; it was an incredibly fragile technical market. There is an easy litmus test to see that it wasn't due to a phantom culprit. First, when the stock market broke sharply, it was already down about 400 points, already a decisive breakdown out of an ugly wedge formation. Then on Friday the market sold down another 270 points, not far from the low supposedly caused by "human error." If a computer error could explain the 1000 points, it seems logical that the Dow would now be back to almost 11,000. This is a convenient explanation, but like everything coming out of Wall Street and Washington, not at all credible.

The critical point is that last week's shenanigans revealed a definitive crack in the foundation of a bullish stock market and the economic recovery. If this market follows the patterns of past crashes (see below) now that we are finally oversold, the coming week should bring an obligatory counter bounce.

II. INTERMISSION: A LIKELY BOUNCE WEEK

Using some references to last week's piece, here is why I think we will see a bounce this week. This lift should set up either the following week or the one after that for "Act Two," an even more dramatic drop in stocks and very likely all commodities, save gold. Please keep in mind that markets have different traits that appear at tops and bottoms of phases. That is why I try to focus on technical stuff instead of news events, earnings, Fed meetings, employment figures and the like. Invariably they are already discounted or irrelevant to the market's direction. Here are some of those characteristics.

  • The market has dropped a little over 10% from top to bottom. Ten per cent is a classic measure of a first down leg and a place where professionals and bargainers like to step in.
  • The volatility index. From a level of almost no volatility for the past couple of months, the VIX shot up sharply from about 16 to almost 45. This kind of violent change should settle back this week, eliciting many public calls that the markets have flushed out the excesses of the past 9 months. Every one except Herbert Hoover will be paraded out on CNBC.
  • The volume in stocks nearly doubled on Thursday and Friday. Although the dramatic change is very bearish, expect the volume to calm down sharply before the primary trend starts down again.
  • The Thursday and Friday syndrome. We have not seen a poor consecutive Thursday and Friday for many a moon. We did this week. I think that the top of the lift will most likely come on a Friday or the following Monday if it follows form.
  • An anticipated government intervention. Given the consistent tendency of the monetary authorities to react rather than to anticipate, I would expect some kind of coordinated attempt to bring confidence back to the markets. It appears that the first one will come out of Europe, but given President We Can Do's mantra, his supreme faith in himself and in the deity of government, the odds are more than decent that Prez O will come up with his own public platform. I hear he has a committee investigating death so he can come up with a government solution. By the way, all death is caused by the environment. Note that he did appear Friday before the American public. Expect to see him early and often over the near future.
  • The put-call ratio. February 8th this year was the highest ratio of puts to calls until this Friday, interestingly almost exactly 3 months later. Also significantly that February day also marked the absolute low of the stock market this year, but now matched precisely by last Thursday's low. Pretty amazing correlation. That match also speaks of a likely one or two week bounce.
  • There are still some industrial charts that lack a definitive break although some new ones did crack. The most ominous (there's that word again) are the charts of the financial stocks which are turning down in tandem. Two essential consumer giants, American Express, which had been holding up, fell from $47 to $41 and Mastercard from $255 to $223. Smells like trouble in consumer city.
  • For the first time in months the market opened down for each of the last 4 days. This broke the pattern that held for almost 2 months. I would think that we will see some persistent higher openings this coming week.
  • There was not one strong close, again breaking the recent pattern of rising markets after 3 PM. But then again we have not had any real selling after 3 PM for months. That should come on the next leg down.

III. ACT TWO WILL FOLLOW THIS INTERMISSION

Even after the past eventful week, complacency and hope still reign. Severe technical damage is evident, but as we see in the media's response to this past week, faith has not been shaken in the American dream. In addition, the longer term indicators remain very bearish.

  • The weekly sentiment surveys remained upbeat. In fact both the AAII (the public) and Investors Intelligence (investment advisors) surveys turned more optimistic last week. Both are the highest they have been in many months. The I.I. is particularly predictive if it stays bullish as stocks decline.
  • The bond market which gave us an alert signal last week that money was flowing out of stocks into bonds is now tremendously overbought (up almost 10 points in a week.) An expected set back usually correlates to a stock lift.
  • The Chinese market continued down--6.3% for the week. The European bourses fared even worse because of their proximity to the Greek crisis and the sinking Euro.
  • Media reaction. On Friday I sent out a remarkable sampling from 6 or 7 online major media sites. Not one featured the point record decline in the Dow either choosing to ignore the story or emphasize that the market recovered and the decline was caused by some mysterious force or person.
  • Barrons. If you look at its current site you would believe that Santa got his months mixed up. http://online.barrons.com/home-page There is nary a warning that things might have changed.
  • The move in gold towards new highs. This move came even as oil sank and against a powerful rise in the US dollar. Many pundits who see gold either as correlated to oil or as strictly dollar influenced are now looking for answers. Gold starting to move up against a falling stock market, rising dollar and falling commodities is not a very healthy long-term sign for the world. This week I suspect gold will pull back if the market does lift. I don't use the word "rally" because that would be too excessive. Just a lift. Gold is heading into the thousands and thousands of dollars.

IV. THE NEXT MAJOR STOP LOOKS LIKE 8,000, AND THEN PERHAPS IN THE FALL, LIKELY LOWER. NOTICE WHERE THIS RALLY ENDED--AT THE BREAK DOWN POINT IN OCTOBER 2008

V. THE UPCOMING WEEK: WHAT I AM EXPECTING

  • A drying up of volume especially if the market rises throughout the week.
  • A quick retreat in the volatility (VIX) index.
  • Some higher lifts in stocks late in the day plus a few higher openings.
  • The market should become dull and listless once again as the initial bargain buyers and short covering wane.
  • A relief in the dollar's pressing strength. My guess is that the strength in the dollar is the primary fundamental culprit in the market's decline.
  • A slight correction in gold.
  • And of course, I expect Jim Cramer to reverse himself once again, as he now turns bullish once again. Don't underestimate how many times he can flip and then flop.

VI. THE COMMON PATTERN FOR MAJOR STOCK CRASHES

There is a certain pattern that evolves in market and sector crashes. It can be seen in the 1987 crash, the gold share market top in 1974 and in the 1929 collapse. At the top the market usually quiets down, might either roll over, or as in the case of the gold shares in 1974 has a quick shot down, followed by a quick reaction back up with much less volume, failing, and then dramatically falls. If this pattern holds, we should run out of volume and then head down in earnest.

VII. CONCLUSION FOR THIS WEEK

You should be out of puts because of the three swing factors--distance, time considerations and a very likely bounce in stocks. Should stocks rally 3% and take at least a week before turning down, the May put series would be cut in half and the June series perhaps by 35%.

  • Be prepared to get back in the following week although it is more likely that the hiatus might extend for two full weeks. The volatility of the market and the volume in the stocks should offer us strong clues.


  • Buy gold and silver on expected weakness if the dollar comes down and if the stock market lifts. I am less confident on silver as it has so far traded like a commodity although the lawsuit against Morgan might change this..


Those who bought puts on the first alerts have done very well, and are now either in cash or should be on the opening tomorrow. But if this week indeed rises, there will be still a terrific opportunity to take advantage of this historic decline. Should we go up to 10,700 or so, that would mean stocks have only dropped about 5%. I think the next leg will be incredibly volatile, and with some luck and planning, we might really nail it. I think I learned something from last Thursday on how to position ourselves for the unexpected air pockets. I realize that puts are risky but as I tried to point out, if you have gold and silver as a central holding, the risk becomes limited. Plus you shouldn't risk much.


If you haven't contacted me and wish to talk about trying something or getting a strategy, please get back to me this week. Honor system. Chuck Chuck ikiecohen@msn.com


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