No Bottom for SPY

Many traders think that the high-volume reversal day that we saw on Tuesday, July 1st was a powerful bullish signal. And I feel that it is my duty to “slap your face and shake you like a rag-doll.” As I crush your hopes and dreams, just keep in mind that it is tough-love, and it’s a lot better than getting your balls crushed if you continue to count on this reversal idea.

For example, Alan Farley at RealMoney.com wrote:

“The major indices posted high-volume reversals near first-quarter support levels in Tuesday’s strong session. This turnaround should prop up equities through second-quarter earnings season…”

This idea will not prove out. SPY will not hold the March low for more than a few days – if that.

First, let’s apply a logical analysis. Why did the market fall to, and bounce from, the January and March lows? In January, a trader at a bank in France was somehow allowed to gamble away the entire bank, which set off a financial panic. As the market plunged, Chairman Bernanke rode to the rescue with an emergency 0.75% interest rate cut. Relieved, the market immediately bounced back up to where it was prior to the crisis.

The March low was very similar to the January low. Another fool bank, Bear Sterns, went belly-up, and again, Chairman Bernanke rode to the rescue with yet another 0.75% rate cut, and a shotgun-wedding deal with JPMorgan to liquidate Bear. The market breathed another sigh of relief and immediately bounced back up to about where it was before.

Now here we are in July, and the market is back to those same panic lows set in January and March. Why? The fool bankers are still running around loose, but there is no panic. The hard truth is that the perception of a “short and shallow” recession is now changing to “long and deep”, and the “worst is over” theme is morphing into a “worst is yet to come” theme.

In other words, the market has returned to the March low for a completely different reason – a much more lethal reason. Not just a fleeting panic, but a realistic assessment of the economy. And we already have evidence that the market is acting differently on this visit to the lows because it has not bounced back up immediately as it did the first two times. In fact, the reversal on July 1st, was immediately reversed itself on July 2nd – something that did not happen in January or March.

Now, how could the market bounce here? Will Chairman Bernanke announce another 0.75% rate cut? No. Will Iran give up its nuclear program? No; Iran is as belligerent as ever. Will stocks respond well to earnings reports? Well, they are not exactly responding well so far; just pull up charts of RIMM, NKE, ORCL, FDX, and UPS – all slaughters.

So, if you believe that the market can hold here, you must have a plausible catalyst to believe in. I can’t think of what that would be. Perhaps you are banking on all the negative sentiment amongst traders. So, let’s take a look at that.

There are quite a lot of traders pointing to the negative-sentiment and saying: “See all that negative-sentiment? That’s bullish.” But ironically, if you have enough traders doing that, it is actually bearish! Here’s one right here:

“With crude soaring past $145 a barrel and prices at the gas pump well past $4 a gallon, investor and consumer psychology is the glummest in decades. So much so, in fact, that the market might be setting itself up for a short-term trading bounce, says Woody Dorsey, proprietor of Market Semiotics. It would be akin to the short-lived rebound from the March lows following the passing of the Bear Stearns phase of the credit crisis.”

That’s what everybody is saying!

Sentiment can change a lot faster than most traders believe, and I think that the big rally on Tuesday burned off a stupendous number of bears. In fact, based on the traders squawking in the blog-o-sphere, I would describe current sentiment as being “hopeful, nervously bullish, and praying to Jesus.” Lots of bears got converted into trapped-bulls on Tuesday.

Here is another example: In “Stock Rally Fizzles but Does No Damage,” Steve Smith writes about traders buying into a hoped-for, up-coming rally:

“And not just traders looking for a snapback rally but buying from institutions that have longer-term time horizon and represent stronger hands in terms of holding positions.”

That’s pure hope, especially when you consider that by all accounts, the institutions have been getting redemptions and selling hard. Perhaps they are stronger hands, but it makes no difference when their investors are bugging-out.

I will also note that there would have been huge “damage” to the market on Thursday if it had not closed early and had a chance to react to the afternoon’s surge in oil prices.

And it’s not just the pundits who are hopeful. Bespoke’s readers are leaning bullish.

So, sentiment will not save the market here. What about the chart pattern? There’s bad news there too. I already noted how the market has not snapped off the lows like it did in January and March. Instead, it has made a different chart pattern – a “broadening” pattern. If you are a bull and you know the implications of a broadening pattern, you will be properly paralyzed with fear at this point. The last time we saw a broadening-pattern situation was when the market tested, and failed at, the previous lows in early January. Take a look at this SPY chart (click to enlarge):

The blue line is the August and November 2007 closing low. As SPY approached, it bounced and created a broadening pattern on January 8th – bounded by the pink lines. Now look at the current SPY chart:

The blue line is the January and March lows. As SPY approached, it has bounced and created another broadening pattern just like in the first chart. This is a very, very bad pattern.

For those of you who don’t know, or don’t believe in technical chart analysis, a broadening pattern means that the Market Beast has gone off of its meds. Perhaps you heard commentators describing last week’s action as “a wild one.” Indeed. What happens when the adult supervision leaves the kids home by themselves? They go wild, and that is exactly what happened last week.

The adult supervision, the big institutions, having completed their quarter-end propping up of the market on Monday, June 30th, pulled their bids on Tuesday, and the market opened Monday on a big gap down, as you might expect. But who would step into a situation like that and gleefully buy? There is only one type of trader that would do that – a short with huge profits popping up on his screen. And so, the short-squeeze rally began immediately. Some small-fry traders jumped in with long positions, and the market scored a rare rally. The volume was heavy because there were a lot of shorts taking profits, and a lot of bulls eager to escape this deadly bear. While superficially it may have looked like large traders with strong hands were stepping in with a far-sighted vision, such was not the case.

Evidence for that came on Wednesday and Thursday when there was no follow-through. No bull-flag pattern developed as you might have expected. Instead, the market popped-and-flopped on both days. That’s what happens when the only sizable contingent of traders willing to buy are the shorts.

Now, don’t go thinking that you are the only trader who has spotted the pop-and-flop pattern. Everybody sees that! Everybody is ready to prick that next pop! Any rally the market can muster will be absolutely crushed by an avalanche of short-selling.

And I might also note here that we bears have all the fire-power now. ALL OF IT!

The mutual funds are getting redemptions. The hedge funds, having shorted the March-to-May rally, took profits furiously in June. They are almost flat now (see the chart at SentimenTrader.com, subscription required) and have huge profits. They are also regretting that they took profits too early! Do you think they will suddenly turn bullish here? I wouldn’t count on it.

In a broadening pattern, anything is possible. We could have another giant short-squeeze rally. Personally, I think such a rally will only come after another plunge. If you are long and want out, this level is probably as good as it gets. And while anything can happen within a broadening pattern, the broadening pattern almost always has bearish implications.

OK, that’s it for the logic, sentiment, and technical factors. Now, what about the fundamentals? Are the fundamentals “sound” like the President and Treasury Secretary keep telling us? Umm….that would be a “no”. The economy is falling apart. Capitalism requires affordable energy, and we simply no longer have that.

Go back and look at the lower pink line on the first chart. Notice how it pointed to the January low. Perhaps the lower pink line on the second chart will point the way for SPY now.

I believe the above is an air-tight case. There is no way the market can rally from this level. If you disagree, please post in the comments.

Note: Last week, I said that I thought SPY would follow the pattern of XLF when it broke-down below the March low. Now that SPY has painted a broadening pattern on the chart, I now believe that SPY’s break-down will not be as orderly as XLF’s break-down.

Note: Those of you who are new to my blog might be wondering just what my credentials are. Well, here are some examples: On June 3rd, I wrote “Stick a Fork in the SPY” and on June 15th, I wrote “No Bottom for XLF“. I traded on both of those ideas and made huge profits. I also predicted that oil would break-out here at a point where everybody “just knew” oil would correct.

This entry was posted on Sunday, July 6th, 2008 at 10:11 pm and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.