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Dow Theory Stock Market Sell Signal - Into The Breach

Stock-Markets / Financial Crash Aug 23, 2007 - 10:07 AM GMT

By: Captain_Hook

Stock-Markets The stock market triggered a Dow Theory sell signal Friday, with both the Dow and Transports closing below June lows, and new lows for the move. Now we have confirmation from a very reliable indicator the stock market is in real trouble to go along with our own observations last week. In relation to this, speculators continued to take put / call ratios down on Thursday, which was part of the reason stocks fell Friday. Just how big a factor put / call ratios are right now is uncertain however, because premiums for puts close to the money doubled Friday, showing extreme pessimism readings not seen by this observer in quite some time. What's more, put positions that matter (on the S&P 500) still outnumber calls almost 2 to 1 (when the SPY and SPX series are added together), so in spite of a possible route in the first few days of this week, I am still hoping for a rally back above 1500 at some point believe it or not. But if put / call ratios keep falling like they have been, with the SPX series down to 1.76 as of last Thursday, I'm not likely to get my wish. 

Below is a commentary that originally appeared at Treasure Chests for the benefit of subscribers on Monday, August 6 th , 2007

What could cause a crash in stocks in spite of the fact internals still do not predominantly support such an outcome at this time? In general, confidence is low on the US right now, with trouble in the White House, the Iraq War not going well, and even the bridge collapse in Minneapolis having an effect. They say stocks have an added burden on them when things are not going well for the President, and they are not. Add to this the perception that the man in control of the money is out of touch, and this could provide such a reason. Apparently all the ‘cake eaters' on Wall Street are calling for a rate cut behind the scenes and Bernanke is confused about the fact this is not a textbook experiment, and comply like Greenspan would have. You see Greenspan made it impossible for him to do anything else based on the mess he left behind via all the other bailouts in the past. Once one starts this kind of inflation-style management, all others behind must follow, and increasingly pander the mob this kind of policy creates as well.

So, if we hear a seriously dovish tone in the Fed's statement Tuesday, things could get interesting, especially if the bond market pops a cord and sells off in spite of expectations to the opposite. That's the big thing that could go wrong right here, because if this occurs, then influential analysts and money managers would read this as a ‘flub' by Bernanke, and start selling stocks in earnest. This in turn would cause a flood of redemption notices to arrive at stock and bond based hedge funds after August 15 th for quarter's end, where these funds would be compelled to reduce both their positions and margin to meet these requests. And you know what that would mean, if record high margin debt levels start to trend lower. Add to this de-leveraging hedge funds would also probably sell offsetting put positions against their portfolios, bringing down supportive put / call ratios on the S&P 500 (SPX) further, and we have a possible recipe for disaster unfolding before our very eyes in coming days and weeks?

Of course if the Fed does cave into the mob's wishes, the dollar ($) will not take this news well, which opens up a different can of worms. If this does turn out to be the case, then I would not be surprised to see a substantial reaction rally (to a falling $) in the stock market, as we should not forget short positions are at record levels. Here, we have record short positions set against record margin debt. Never before in history have ‘key market internals' been so profoundly diametrically opposed, with key factors supporting continued buoyancy in stocks set against those that oppose, not the least of which look to involve increasingly profound credit market dislocations and derivatives related disasters . Bottom line in this respect, with forces pushing and pulling prices in both directions, it's safe to say that at a minimum, increased volatility should be expected in coming days, and that portfolio planning should be performed with this understanding in mind.

What to do? While this subject was well covered last week, the fact both precious metals stocks and the metals themselves were attempting to rise Friday might be confusing considering we are recommending caution at this time. Obviously precious metals are rising here because some investors are front-running an anticipated loosening of policy by the Fed very soon, like this week, which should lift all boats for a period of time. Additionally, this is also partly a study in human behavior in that when put in harm's way; humans have a tendency to react by running, which in this case, involves buying gold stocks. In the larger scheme of things however, lest we forget that if the stock market is to ultimately resolve lower once short positions have been burned off sufficiently, and declines are to be considerable, then, like the experience in the year 2000, precious metals should decline in sympathy due to a loss of liquidity for approximately six-months.

Fast forward to today, and we have a top in stocks in July, which would mean that if history is to repeat in this measure, a bottom in precious metals shares should not be anticipated until December. What's more, let's not forget such an outcome would be 20-months from the peak in the sector observed in May of 2006, which would mean if a bottom were to occur in December, the current mid-term correction for gold would match that of the 70's time wise. Now wouldn't that be interesting? What's more, such an outcome would be consistent with our view an attempted recovery in the stock market will be engineered before year's end as per Presidential Cycle considerations, where it would not be surprising to see precious metals reacting favorably to an accelerating inflation agenda in order to accomplish such a feat.

So, in answer to the question of what somebody should do here, we have the following response in point form, as follows:

•  Establish a properly diversified / balanced / structured portfolio based on your personal investment parameters, including risk tolerances and time horizon.

•  Ensure this composition includes a healthy component of cash to take advantage of opportunities in case liquidity related event becomes a reality this fall.

•  In adding companies to your portfolio, endeavor to ensure they appear poised to out-perform, which generally means they should possess better capital retention characteristics as well. 

•  If we do see a short squeeze in stocks over the next few weeks, consider adding hedging positions assuming internals appear favorably predisposed.

In terms of this last point, we will obviously keep you abreast of the situation, and assuming an opportunity makes itself available, meaning the SPX rallies back above 1500 in concert with put / call and short ratios falling, we will also aid in security selection at the time. This time around we will not only point out some options that appear to have favorable characteristics, but also at least one shorting fund for those who don't like the constraints found in these derivatives. In this respect, I will be back throughout the week talking about security selection as it pertains to the metals at first, and then if we get our broad market rally into options expiry on the 17 th , some shorting opportunities later on.

All this of course assumes stocks don't continue down here, as that was quite the nasty close on Friday. If the Fed disappoints this week anything is possible in this regard. If they pander the mob however, a rally should ensue considering how close we are to options expiry. So, it will be interesting to see how Bernanke handles his first difficult test here. If it's perceived he failed, for whatever reason, gold will go considerably higher, if not at first due to liquidity related reasons, afterward for sure.

This suggests to me holding precious metals appears to be a good idea given the totality of risks present in the financial system, which is exactly what people who are tuned into these risks are doing. And increasing numbers are seeing the light every day, with volatility in paper empires becoming more evident, so it should not be long before we have a great deal of company. Thus, one should remain focused on expectations into 2008 that appear very promising, allowing near term volatility to work in your favor in presenting opportunities to accumulate on the cheap. Remember however, leave the margin for the other guys in riding golden waves higher in comfortable fashion. Too many allow greed to be their undoing, which is tragic considering the scope of opportunity before us.

Unfortunately we cannot carry on past this point, as our opinions on further developments are reserved for subscribers. However, if the above is an indication of the type of analysis you are looking for, we invite you to visit our newly improved web site and discover more about how our service can help you in not only this regard, but on higher level aid you in achieving your financial goals. For your information, our newly reconstructed site includes such improvements as automated subscriptions, improvements to trend identifying / professionally annotated charts ,   to the more detailed quote pages exclusively designed for independent investors who like to stay on top of things. Here, in addition to improving our advisory service, our aim is to also provide a resource center, one where you have access to well presented ‘key' information concerning the markets we cover.

On top of this, and in relation to identifying value based opportunities in the energy, base metals, and precious metals sectors, all of which should benefit handsomely as increasing numbers of investors recognize their present investments are not keeping pace with actual inflation, we are currently covering 62 stocks (and growing) within our portfolios . Again, this is another good reason to drop by and check us out.

And if you have any questions, comments, or criticisms regarding the above, please feel free to drop us a line . We very much enjoy hearing from you on these matters, although we may not be able to respond back directly, so please do not be disappointed if this is the case.

Good investing all.

By Captain Hook

Treasure Chests is a market timing service specializing in value-based position trading in the precious metals and equity markets with an orientation geared to identifying intermediate-term swing trading opportunities. Specific opportunities are identified utilizing a combination of fundamental, technical, and inter-market analysis. This style of investing has proven very successful for wealthy and sophisticated investors, as it reduces risk and enhances returns when the methodology is applied effectively. Those interested in discovering more about how the strategies described above can enhance your wealth should visit our web site at Treasure Chests

Disclaimer: The above is a matter of opinion and is not intended as investment advice. Information and analysis above are derived from sources and utilizing methods believed reliable, but we cannot accept responsibility for any trading losses you may incur as a result of this analysis. Comments within the text should not be construed as specific recommendations to buy or sell securities. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities, as we are not registered brokers or advisors. Certain statements included herein may constitute "forward-looking statements" with the meaning of certain securities legislative measures. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the above mentioned companies, and / or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Do your own due diligence.

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