Why the Stock Market’s Next Leg Down Likely Began Today

Why the Stock Market’s Next Leg Down Likely Began Today

Since the stock market put in a short term bottom a couple of weeks ago (thanks to overwhelming pessimism), the mini-rally since has been a one-way street UP – until today.

This has been the trend of the market since about 2003 or so – it’s either up for many consecutive time periods (like 2003-2007, March 2009 – April 2010), or down for many consecutive time periods (2007 – March 2009, April 2010 – ?).

Also interesting is the “fractal” nature of the advance and decline streaks that is emerging within these larger trends.  Since the stock market topped in April, it’s been ebbing downwards in a relatively orderly series of “waves”, with the successive “lower lows and lower highs” that usually signal a downward bearish trend in place.  Stocks will decline for a few weeks – then they’ll increase for a few, but not take out the previous highs.  Then down for another few, taking out the last set of lows, and so on.

So when this rally began, regular readers know that we were licking our lips, looking for an appropriate entry point to “go short” once again.  I wrote before Tuesday’s open that it looked like the latest “mini-rally” was running out of steam, and that I had re-initiated my S&P short position (albeit too early…but when declines are this sharp, I’d rather be early than late.  And in this case, it worked out, as the position is now profitable).

Today’s decline was very powerful in breadth and depth.  It happened about when it should have (after restoring optimism to the markets).  So it looks like we may be setup for a resumption of the decline, with an upcoming leg that should take out the June lows.

S&P 500 price chart July 16 2010

Just about on cue, the S&P turned down sharply and violently after retracing much – but not all – of it’s previous decline.

(Source: StockCharts.com)

And how’d gold do today?  Not too hot – down $20!  The “safe haven” relic is hanging on for dear life, well below it’s June highs.  To me this looks like a repeat of gold’s 2008 performance – when it hung on longer than equities, but ultimately got body slammed by the Deflation Bird.

Remember, the last HUGE wave of deflation took no prisoners – hence I’m not convinced gold will be safe this time around either.

How should you invest during these deflationary waves?  Cash is probably the safest place to be.  For those of you with a speculative flair (like myself), it may be profitable to short the market, particularly on the inevitable bounces that get investors feeling bullish and happy once again!

In closing, we’re now profitable on our short position, and we’re planning to hold this baby through the next leg down, if that is what ends up transpiring.  A breach of the June highs would indicate we are wrong, at which point, we’d need to re-evaluate our stance.

S&P E-Mini Short Futures Position July 2010This short position was a big fat LOSER – until today!

And if you’d like to get caught up on our “shorting the S&P 500” trades – here’s the last one we (fortunately) covered near the bottom of the last leg down.  It was far more luck than skill on timing 🙂