Archive for October, 2011

Signs Evident of Impending Crash?

The fact that the market crashes from time to time is indisputable. And with the rapid growth of globalization, there is a very good argument that these crashes will increase in frequency and severity as we go forward. To this end, there is no doubt. The question is when will these crashes occur? Some might say that a crash will occur when there is exceedingly bad news. But, whose job is it to determine what level of bad the term exceedingly represents?

Truth be told, there are many different potential catalysts that can cause a crash. Right now, we have three or four of these catalysts out there. But in reviewing previous crashes, it is plain to see that the catalysts are very diverse in nature. However, diverse catalysts be damned, there are two factors that always seem to be present. The first is an over-optimistic exuberance where the market trades up on hopes and emotions as opposed to real numbers and realistic expectations.

The second is a lack of shorts in the market. I know it sounds funny and that you would think the reverse would be true. But, it is not. You see, the short side traders are almost exclusively professionals and institutions. As professional traders, they are very likely, if not almost certainly going to scale out of their short positions. Scaling out means that they will buy back their short positions in pieces at different levels as the market or specific stock trades down.

Normally, these levels are determined by technical analysis. Due to this process, the shorts actually stabilize the downward movement of the market by their purchasing on the way down at support levels. This helps prevent a crash. The participation of the shorts helps the market to trade down in more of a “stairway” looking charting movement as opposed to an “elevator shaft” downward movement that is a crash.

Today, both of these two factors are present in the market. Each of the past three rallies has been powered by an over abundance of optimism. In the current rally, the spark was word that both Germany and France have agreed that they need to sit down and work out a plan to help stabilize and secure capitalization of the European banks. The market rallies 1000 DOW points simply because two parties decide to talk? What if they can’t come to an agreement? What if the plan they hatch is not big enough? What if it simply doesn’t work? We are this excited about the fact they are going to talk? And we did not know this? This is news? Good enough to run the DOW 1000 points? Kind of optimistic aren’t we?

The rally prior to this one was powered by expectations that the Fed was going to possibly initiate QE3 which the Fed had already made clear that it was not going to do. Prior to the rally, the Fed even said that it was going to use a tactic called “The Twist.” Yet investors still bought up the market like crazy with the hopes that the Fed had been lying and was going to surprise us with QE3. The Fed did the “Twist” and not QE3 and the market sold off hard. Same type of thing happened the time before that too. There is just way too much optimism again…..and still!

The other note of concern is that each of the last three rallies has started with short squeezes chasing the shorts out of the market. This is evident with the speed of the rally and how quickly the volume dies out on it. This is very typical of a bull rally in a bear market. At some point in time, enough shorts are missing from the market and as we approach a support level, we break it aggressively because there is no one at the support to buy. As we approach the next support level we again see no buyers because no one is short. Next thing you know, we are falling off a cliff with supports being broken like a hot knife goes through melted butter! Then, it is on…..a crash!

Now, I am not necessarily predicting a coming crash. I am just saying that the two major factors that must be in place are in place right now! TREAD CAREFULLY!!!