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At the Precipice: When Everyone's Fearful...Sell?


Tuesday, August 24, 2010 - A few days before the July 2010 rally ended, I presented evidence suggesting the broader market was headed for an impending collapse (see here). Since that time there has been rampant discussion of Hindenburg Omensmarket dandruff, deflation, double dip recessions and illiquidity in the popular media. The cat is out of the bag. Is it time to go long or will the market unwind despite the general knowledge of very negative indicators?

By now, everyone knows or should know there’s a major 10-month head & shoulders on the S&P 500, Dow and NASDAQ, and that the Hindenburg Omen has been repeatedly confirmed since it first appeared on August 12, 2010. When Maria Bartiromo discusses head & shoulders, and when Jim Cramer talks Hindenburg, that’s when “smart money” knows its time to get out of the short trade.Anytime bearish sentiment becomes popularized, it’s almost certain to be a contrarian indicator. 

Don’t believe me - just ask Art Cashin, director of floor operations at UBS. In July 2009, when a head & shoulders pattern on the S&P 500 became popularized and broke to the upside, he told CNBC, “the market will always do what it can to make fools out of as many people as it possibly can.” Translation: fund managers are always looking for pockets of liquidity to either take or unload positions in the equity market, and triggering a short-covering rally is one such pocket of much needed liquidity.Traders were positioned short ahead of a predicted unwind of the June 2009 head & shoulders, and when the market gapped up the Monday following a breach of the neck-line, a massive short covering rally ensued over the next 3-week period.

So the question that should be on everyone’s mind is given the fact that everyone is aware of this 10-month head & shoulders, the Hindenburg Omen and September crash thesis, does it now necessarilymean a collapse is no longer in the cards?

I’ve been generally bearish on the equity market since April (see here), and have made a killing on both short and long trades over the past several months. Yet, the one thing that keeps me up at night is the fact that too many people could be positioning short ahead of a potential September sell-off.That it’s becoming a crowded trade, so to speak.

This is or should be the largest concern for the short view right now. However, that being said, I think it’s becoming exceedingly likely that despite the fact that much of the market is generally aware of these obvious warning signs, it will do very little to stave off a significant sell-off that will probably bring the Dow to 8,800 or lower. In the vast majority of cases, I would agree with the convention that rising expectations of a sell-off lowers the general probability of that sell-off actually occurring.However, in this particular case I think we’re headed lower despite this long-standing principle.

First, institutional buying has fallen off a cliff over the past several weeks indicating a lack of accumulation that generally precedes a big move up in the markets. Instead of buying on weakness, institutional investors have moved to the sidelines since the end of July. In fact, institutional buying has dropped to the lowest level in more than year and has been steadily declining since June. This significant lack of accumulation can only be interpreted as a shift to a far more defensive stance by big money. If the market is really set to rally against this head & shoulders formation on the S&P 500 as some might suggest, we would see a lot more conviction from institutional investors. Read more atCobra’s Market View.

Secondly, it’s not as if everyone is just piling into puts going into September. According to the $CPC, an index that tracks the daily put-to-call ratio on the Chicago Board of Options Exchange, far more traders are currently positioned long than short. Most of the time, when we get a low reading on the $CPC it’s a leading indicator and suggests the market is likely headed higher in the short term. In fact, based on a back-test performed at Cobra’s Market View, in 41 out of the last 59 cases (70%) where the $CPC closed below 0.81, the market closed in the green in the following trading session.

Yet, there are times when the $CPC can be a contrarian indicator. If everyone and their mother piles into short or long positions, it could implicate a change in trend. In fact, that’s exactly what we saw in April when the $CPC closed well below 0.60 suggesting that the market participants were simply getting too bullish. A reading of 0.50 suggests a 3-1 call-to-put ratio.

Just a week after that extreme April reading, the market commenced the biggest correction in over a year. We also saw the same happen in the opposite direction when traders got overly bearish in late June as indicated by a close above 1.50 on the $CPC (3-1 put-to-call ratio). Though investors saw a few days of continued selling pressure after the extreme reading, the market quickly reversed course and saw a massive rally in July.

Based on Monday’s relatively extreme close of 0.71, way more people are betting the market is headed much higher rather than lower at least in the short term. This indicates that though market participants might be aware of the Hindenburg Omen, the head & shoulders on the S&P 500 and the general crash thesis, they’re certainly not positioned that way.

So while retailers continue to buy large amount of calls on equities as we head into September, institutional investors have been moving to the sidelines. Usually, we only see this type of activity at market tops, not bottoms. Though the market has been in sell-mode for the past several weeks, trader sentiment has been generally bullish based on option activity.

Yet, putting all of this nonsense aside, here’s the bottom line. Everyone who is anyone has their eye on 1010 and 1130 on the S&P 500. If we break below 1010, we’re headed much lower. At least to 950, which happens to be the 50% retracement of the March 2009 to April 2010 rally. Whether the market goes any lower than 950 will largely depend on market sentiment come September/October.

If, on the other hand, we break above 1130 on the S&P, then we’re likely headed to 1300 or higher by year’s end. There is at least some evidence suggesting this is somewhat possible. There’s a clear 6-week inverse head and shoulders on the S&P 500 with the neckline sitting at 1130. Inverted head & shoulder patterns are very strong bottoming formations and should be taken seriously. In fact, the 2007-2009 bear market bottomed out with an inverted head & shoulders pattern.

Those are the two lines in the sand, and everyone knows it. What’s left to be determined is the potential catalyst that can drive the market beyond 1130 or below 1010. Right now, the evidence clearly indicates the market is far more likely to break down than rally out. For one, the economic data has all been very negative over the past several weeks. The market absolutely hates uncertainty, and the economic outlook is very uncertain at the current moment. Any piece of economic data can spark a major sell-off. Weak employment data for August can send this market spiraling. Last week’s Philly Fedindex was just but one example of how the market can be unpleasantly surprised by weak economic data.

Market Opportunities
A sell-off to 950 on the S&P 500 will likely present some good long-term opportunities. Starting with my all-time favorite, Apple (NASDAQ:AAPL) has been and continues to be the super star of the NASDAQ-100 (QQQQ), and the long-term outlook for the stock looks very bright. Yet, in the short term, the stock could easily see the low $200’s before this correction is over. At that price level, I’ll likely be considering a long position in some 2012 leaps. Apple closed at its 5-month support of $245 on Monday. Despite Apple’s strong fundamentals, it has a long history of following the general direction of the broader market. Heavy selling in the cubes (QQQQ) continues to put a lot of pressure on the stock.

Bond yields will probably continue to contract as we head into September and October making the 20+ Year Treasury Bond Fund (NYSEARCA:TLT) a good candidate for a short position as it climbs to ungodly levels not seen since December 2008. At the 50% retracement, the broader market ETFs (NYSEARCA:SPY) or (NYSEARCA:DIA) could be an attractive long-term play. Google (NASDAQ:GOOG) could see the low $400’s on a final leg down in the markets likely making it attractive to institutional investors looking for value.

Intel (NASDAQ:INTC) continues to post very strong earnings, and is once again, like Apple, the innocent bystander in this sell-off. Though the name sits at the lows for the year, it does have a gap to fill in the low $16 to $17 range. If Intel happens to see that level, it is sure to attract a ton of institutional interest as a steal on value. Goldman Sachs (NYSE:GS) is another name I’m looking at very closely. If it can hold support at $130, it’s likely to be very attractive to long-term investors. Personally, if I do ever invest in individual names, it’s always best in breed – a benefit of not having a massive liquidity problem.

Disclosure: At the time of this writing, the author holds not position in the equity markets. Though that is likely to change at any moment. The information contained in this writing is not to be taken as an investment or trading recommendation and serious traders or investors should consult with their own registered financial advisors before acting on any thoughts expressed in this publication.