Is the Monday Market Meltdown in Europe Setting the Stage for a Panic Bottom on Tuesday?

By: Michael Swanson | Tue, Jan 22, 2008
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Is the Monday Market Meltdown in Europe Setting the Stage for a Panic Bottom on Tuesday?

For the past few weeks I have been telling you to hold off on buying anything until we saw signs of true fear in the market. On Thursday, we finally saw panic start to set in. As the DOW fell over 300 points, the VIX, which measures the premiums that options traders are willing to pay for volatility, spiked up over 10% to close right under 30. That night I put together a buy list to use the next day. I thought to myself, "We are on the verge of a panic bottom in the market."

But on Friday, the DOW gapped up. This was due to earnings from IBM and GE and the promise of a stimulus proposal from President Bush. The market sold the gap up and then fell back into the red, with the DOW falling over 120 points at one point to drop near the 12,000 level. The S&P fell all the way down to 1312. Several weeks ago I listed 1300 on the S&P as the furthest extent that I saw this correction going. By anyway you measured it, the market had become extremely oversold.

As I watched the market fall on Friday I did not get the feeling that we were seeing a true panic washout yet. The VIX merely traded back up to its previous level the day before, never reaching the levels it reached in November and August. Last week's Investors Intelligence survey even showed fewer bears than there were in November and a fraction of what we saw in August. In other words, sentiment surveys and options indicators did not quite give the readings associated with major market bottoms last week. On Thursday they began to get close, but they have not yet gotten there yet. What I find even more interesting is that the internal market readings did not show any panic at all. The ratio of down to up volume on the Nasdaq was 63% to 36%, while 61% of Nasdaq stocks declined and 35% rose. Over the past few years, bottoms have come with readings of 90% down volume, with major bottoms usually occurring after a string of such days.

On Friday though I came to conclude that there was very little downside left to the market for the short-term barring a stock market crash and did some buying. When the US markets made a new low Friday it didn't have a big sell-off. It just churned around for a few hours and attempted to build what appeared to be a base above DOW 12,000 and S&P 500 1300. On a 60 minute chart the stochastics for the S&P 500, DOW, and Nasdaq are all oversold and have been oversold for a day and a half. If the S&P 500 simply would have held in a 20 point range above Friday's low of 1312 for the first few hours of Tuesday's trading session the 60 minute bollinger bands would have come together. 1330 on the S&P 500 would have been the key pivot point to watch.

However, on Monday as I write this markets all over the world are trading down 5% in what are crash like conditions. Monday at 9:30 AM DOW futures are down 300 points and S&P 500 futures are down over 50. If the US markets open down like this on Tuesday than we are going to see the VIX spike up and a huge jump in the put/call ratio. There will be the type of fear associated with major market bottoms - in fact we should see just as much or possibly even more fear than we saw at the August bottom. If the market opens down like this I would expect it to be weak in the first half of the day and reverse by the close, unless we are witnessing a once in the lifetime crash here, but you have to deal in probabilities and expect tomorrow to be a panic washout reversal.

I bought some on Friday, because of the possibility of the market gapping up Tuesday after trying to stabilize on Friday. I will be watching the action carefully Tuesday and will likely add on to my positions.

The market was already extremely oversold on Friday, and that is why I did some buying, and will be even more oversold if it opens down on Tuesday. In fact it will be more oversold than it has been in ten years. For instance take a look at the bullish percent charts:

The Nasdaq bullish percent isn't an indicator I really use to make buy decisions, but it is one closely followed by my good friends Matt Frailey and Dave Skarica. The Bullish Percent Index (BPI) is a popular market breadth indicator that is calculated by dividing the number of stocks in a given group (an exchange, an industry, etc.) that are currently trading with Point and Figure buy signals, by the total number of stocks in that group. Bullish Percent levels that are above 70% are considered overbought, whereas levels below 30% are considered oversold. Strong buy signals occur when the Bullish Percent Index falls below 30% and then reverses up by at least 6%. Conversely, promising sell signals occur when it goes above 70%, and then reverses down by at least 6%.

On Friday, the bullish percent for the Nasdaq closed below 20 to give the lowest reading it has given in ten years.

The most popular version of this chart is the NYSE Bullish Percent, which is mentioned prominently in Thomas Dorsey's book, Point & Figure Charting. It also gave a 10 year low reading on Friday.

Of course, when you look at the charts the first thing you think is that this indicator is so low now that it means the market is totally oversold and will go up. That's right. The only way it doesn't is if it totally crashes right now and it has only done that once in the last 100 years. Personally, every time I've seen it in a situation where if it falls more it is going to crash, it goes up.

However, what I want you to notice is this....Are you ready? In the past 10 years we have seen four major spike downs below 24 in the Nasdaq bullish percent. All of them came after major declines in the market and huge levels of fear registering in the VIX and Investors Intelligence survey. They also came during times of scary news. The 1998 low was associated with Russia defaulting on its debts and the collapse of the Long-Term Capital management hedge fund. The 2000 spike down was during that Spring when Internet stocks blew up and that bear market started. Fear reached a crescendo and I remember watching CNBC commentators visibly shaken. Even Jim Cramer was sweating profusely that weekend! And the 2001 bottom was associated with the September 11th attack. Once again, the surveys showed fear at the bottom.

If the market falls hard Tuesday and bottoms this week then we will be witnessing a similar type of bottom - once again related to true panic in the markets and bad news - this time being the banking crisis and difficulties the Fed is having in patching it and the economy back up. I see this as a panic drop within an ongoing bear market, but I expect the markets to have a huge 10-15% countertrend rally once this current drop is over.

The S&P 500 appears to now be locked in a downtrend channel. It has resistance in the 1445-1474 zone. 1445 is the 50% retracement of the 15% correction from the October high to December low for the S&P 500. 1474 is the 2/3's retracement level. More importantly, the area in between is home to the 150 and 200 day moving averages for the S&P 500. The most logical end point for a rally in the S&P 500 is its upper resistance downtrend line. This downtrend line is currently at around 1475 but will be in the 1455-1460 area in a few weeks. 1450 is my target for the S&P 500 on a rally and where I would take profits on a countertrend rally from here. That's a 10.5% gain from the 1312 low of the S&P 500 on Friday, and would be even a larger percent gain if we see the market go lower tomorrow.

Hold on to your hats this is going to be a wild ride. We already have the market oversold enough to put in a major bottom. Now it looks like sentiment is going to get in line too.

Dave Skarica and I published a podcast Monday morning about today's sharp drop in overseas markets and the likelihood of a sharp drop on tomorrow's open for the US markets. You can listen to it by clicking here. To subscribe to Dave's Addicted to Profits go to this link.

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WSW Podcast: US Market Poised to Gap Down Huge Tuesday.



Michael Swanson

Author: Michael Swanson

Michael Swanson,

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