IS A CRASH COMING?
Earnings season in the US has started with a big bang as Alcoa beat its earnings estimates after the close on Monday.
Traders have aggressively bid stocks up over the past 6 days you have just got to listen to the excitement in the air on CNBC, the tone is now BUY two weeks ago people were worried about bear markets and technical indicators such as the “death cross,” but now those worries are all gone and people are now worried about missing out on more stock market gains.
Personally I have turned bearish on the market for the rest of the year and believe that this rally will be a good opportunity to sell and to go short if you want to make money.
Historically the market tends to pop at the beginning of a quarterly earnings period and then top out in the first 3-10 days of the earnings season. Even in bull markets it usually peaks and corrects. So I would not get too excited about earnings and would NOT buy into this rally.
I know that is hard for most people they associate the stock market going up with making money and want to be a part of that. That’s why rallies in bear markets just suck everyone in and people have such trouble using it to sell especially when everyone on TV gets excited. It’s just too hard for the average investor to go against what people on TV tell them to do and think.
But chasing news is not how you make money in the stock market. Traders buy the rumour and sell the news. Suckers see the news out, see a stock up 5%, and buy based on emotion – usually from the very traders who bought ahead of them or from smart money cashing out. News is used to sell the stock market to the average investor.
The market froth is being caused by nothing other than technical trading, so I finally had to ask myself the question: Are investors being set up for another crash?
The longer the market ignores economic reality, and the more the market gets driven by high-frequency trading programs, the greater the likelihood of a crash. And with the double-dip recession that is all but inevitable, another market crash will quickly evolve into another Great Recession.
SHORT-TERM MARKET OUTLOOK
The S&P 500 (SPX) has been on a rise upwards over the past six trading sessions, with the important numbers being 1,100/1,120 on the S&P. During the past few weeks we have been making lower lows and lower highs. If we make a lower high that tops out below 1,120 it will be a signal this upward correction is over.
It may also signal a sharp downturn capable of producing a lower low at around 1,000.
So, short term, watch the 1,100/1,120 level, and if the market fails to punch through, it will be time to put new money to work on the short side.
IS A CRASH AROUND THE CORNER?
The possibility of a real panic hitting Wall Street increases every day, why?
First, the mindset on The Street is to continue to ignore the reality that is this awful economy, and the likelihood of good second-quarter earnings are buying this bullishness.
In the past few days stocks have moved together in tandem at a rate not seen since the days before Bloody Monday, Oct. 19, 1987 — a crash that was driven by program trading.
Program trading is the grandfather of today’s high-frequency trading programs and is dominating the day-to-day movements in the market.
Remember what happened on May 6th in 15 minutes the Dow plunged 1,000 points they blamed it on the fat finger trade.
This trend is boosted by the growth of exchange trade funds (ETFs). Investors who do not like the banks can now buy puts on the entire segment, not just a set of individual stocks.
Its high-frequency trading and the shift to ETFs that are forcing an ever larger percentage of stocks to move in tandem with the market, up or down. And the bigger the percentage of stocks moving in tandem, the harder they fall together and when they fall together we could see a crash.
What other surprises should we look for?
1.A major U.S. bank failure or surprise such as a big national or regional bank saying it needs more private capital or needs TARP money.
2.A big surprise in major economic data such as a quick jump to 11% in unemployment or a drop to less than 1% GDP growth in Q3.
3.The default or major downgrade of state bonds, such as Illinois, New York or California.
4. The European stress tests revealing bigger problems than anticipated and European governments failure to provide more capital for problem banks.
5. Bad economic data from China something that would send shockwaves through the markets.
How bad could a crash be? The logical target is the previous low at 667 on the S&P which was the intraday low Friday, March 6, 2009.
Several longer-term market technicians believe a violation of the 660 level for more than a few days would push the market to 500 or below. I believe a crash would begin to slow at around 10% above the previous low or 730, still a serious 33% drop from today’s levels.
A crash would have an immediate impact on the economy. Business and consumer confidence would take a hit, consumer wealth would take a hit and the combined impact would turn the double-dip recession into a double-dip Great Recession. Unlike the past Great Recession, there will be no quick rescue.
What did the government do last time?
Congress created the $700 billion TARP, providing a financial backstop to wobbly banks. Uncle Sam handed out a $787 billion stimulus package, saying “we will not let the economy fail.”
The first cash hit the economy in late February in the form of larger taxpayer refunds and hundreds of billions of dollars to states to retain teachers, police and firemen and pay other pressing bills. Stimulus plus TARP equalled $1.6 trillion.
Uncle Sam and the Fed conducted powder puff stress tests and reported results that told the markets “we will not let our banks fail, no more Lehman Brothers.” The outlines and criteria of the tests were made available in mid-February within a month of the stress test announcement the rally began and markets took off.
Uncle Sam changed the accounting rules so toxic assets did not have to be written down, they are still there lurking and commercial real estate loans did not have to be changed if the value of the mortgaged property dropped. Those toxic loans are still out there.
The Fed flooded the market with liquidity by expanding its balance sheet and lowering interest rates to zero, in the process expanding its balance sheet by more than $1.5 trillion dollars. When you add up the stimulus, the TARP and the Fed liquidity moves, the number is greater than $3 trillion.
What would happen now if there is a crash and another Great Recession?
You can count out more TARP. There is no political will to produce more capital for banks. Voters still hate the banks and the politicians know it. Banks that wobble will be put into receivership along the lines provided in the new financial reform bill, and this will dry up credit among banks in the US and in Europe. The current credit crunch will get far worse.
No more fiscal stimulus. Given the current federal deficits and a looming election dominated by Tea-Party-generated headlines, the Senate couldn’t even pass an extension of unemployment benefits, let alone more stimulus.
No more liquidity. It’s hard to imagine the Fed will expand its balance sheet any more, except to address a very short-term liquidity crisis. And interest rates cannot go lower.
I see this as just the start of an ugly market drama that will play out over the next 12 months.
Of course it won’t be ugly for us; rather it will be very friendly for our short-side plays. Stay tuned.
Be patient and let’s see where the market goes during the next days or weeks before putting any new money to work.
The market is at an inflexion point and could turn down sharply if it bounces off 1,120 on the S&P.
As always, I’ll send you Alerts when the timing is right.
Trader Lyn
