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Since the 54 point correction in the S&P 500 in late November the market has been on a virtually unabated 130 point rally from the lows on November 30th. Feedback cycles in markets have a long history of being vicious and lasting much longer than market participants expect. The recent hubris of the bulls who buy each and every dip and expect stock prices to rise each and every single day is clearly unsustainable. However, calling market tops is notoriously a fool’s game and market corrections are usually catalyzed by unexpected events- so called black swans.

Just after the market open, with the S&P 500 tapping above the 1302 level market participants had thus far been ignoring the Egypt situation. Perhaps market participants were also looking forward to a healthy $8 billion serving of POMO (NY Fed permanent open market operations) that would arrive at 11am. Meanwhile, throughout the morning the Egypt situation continued to escalate to the point that much of the Egyptian police force had given up their attempts to break the protests.

One never knows exactly how a major market selloff begins but we can certainly analyze the conditions which existed preceding the selloff. Here is a daily chart of the SPY heading into today:

(Click to enlarge)

Notice how small many of the recent daily candles have been, also notice the low volume since the end of last year- The SPY hasn’t had a 200+ million share volume day since December 7th, 2010. Now look at a chart of the VIX (a measure of the implied volatility of S&P 500 put options, one of the best equity market fear gauges):

(Click to enlarge)

It is easy to see that the VIX hit a low of 15.37 on January 14th: The last time the VIX was this low (15.23) was on April 12th, 2010, two weeks before the market began a sharp correction (17%). Today happens to mark exactly two weeks since the January 14th low on the VIX. Is this a coincidence? Yes, perhaps it is although when combined with several additional worrying factors it is easy to see that the equity markets were highly vulnerable at S&P 1300. Here is a list of some of the most important preconditions for a market top, all of which were present heading into today:

  • Overwhelming complacency exhibited by market participants, evidenced by historically low VIX readings and a pervasive “buy the dip” mentality.
  • A crumbling of the "wall of worry" in recent weeks as the Eurozone sovereign debt crisis appeared to be resolving and market participants continued to display historically high bullish sentiment.
  • Continued signs of economic/market troubles ahead in Asia as China/India wrestle with alarmingly high levels of inflation- Asian markets have been correcting for months.
  • The prospect of the Fed foregoing any possibility of QE3 and the potential for the market to begin pricing in the end of HIGHLY accommodative Federal Reserve monetary stimulus.
  • Municipal debt crisis in the US along with the prospects for further municipal sector employment cutbacks and increased state/local tax rates.
  • Downgrades of the formerly bulletproof sovereign debt ratings of Japan & U.S. (U.S. was placed on negative outlook by Moody’s not downgraded).

One never knows the specific catalyst or timing of the proverbial "straw that breaks the camel’s back" but rest assured, as the straw piles up on the camel’s back it becomes more and more likely that the next straw piled on will be the last straw. Markets are no different in this respect, as they reach increasingly lofty levels, the margin for error becomes smaller and smaller. The black swan is by definition completely unexpected in nature. Are the Egyptian/ Tunisian revolutions the new black swan?

We do not know the answer to this question yet. However, for at least one day the situation Egypt has wrested control away from the equity market bulls. A shutdown of the all important Suez Canal (world’s most important oil shipping waterway) is a very serious possibility and today the oil markets reacted violently to this possibility. Moreover, the possibility of a domino effect of Arab rulers being toppled in popular uprisings is the most potentially geopolitically destabilizing scenario that could play out.

In his weekly market commentaries, John Hussman has been preaching the existence of an "unpleasant skew" for several months. Hussman defines "unpleasant skew" as “a tendency for the market to make a series of successive, marginal new highs, typically resolved by an abrupt plunge that wipes out weeks or months of upside progress in a few sessions.” Of course, eventually Hussman’s unpleasant skew will prove to be correct at some point. Is this the beginning of an “abrupt plunge that wipes out weeks or months of upside progress in a few sessions.” In my opinion the odds are in favor (65%) of a yes response to that question. A return to S&P 1250 would wipe out all of January’s gains and serves as a reasonable downside target for a correction.

Source: Is Egypt a Harbinger of a Correction for the Market?