Market Update: The Damage Has Been Done

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September 2, 2009

Stocks are back in the black today after a very tough start to the week, but is the rally too little, too late? We believe it is, though we don’t necessarily feel it’s the end of the world for investors.

We’ll detail the idea below, but we first want to let you know where the analysis is going… the market is due (overdue, actually) for a normal corrective action. September is a losing month - on average - for stocks anyway, so it makes sense the corrective move is playing out now.

OK, with that on the table, here’s what we’re seeing…

Before jumping to any bullish conclusions about today’s modest gains, we’ll remind you if you drop anything from high enough, it’ll bounce. And, stocks certainly fell a great distance yesterday. That’s why we’re not going to focus too much on today’s action, and instead will highlight the fact that August’s anemic bullish streak has been broken thanks to losses on Monday and Tuesday.

The problem is, we’ve seen these stumbles before over the last six month, yet none of them really took hold in a meaningful way. What makes this one different?

As it turns out, the “What makes this one different?” question wasn’t just rhetorical…. this one really is different. The prior ones we’re never really interpreted as a serious threat to the uptrend… this dip has actually spooked people. And, if investors are truly fearful, they’re going to behave accordingly.

The evidence of this fear comes in the form of the VIX… the CBOE’s ‘fear gauge’. The higher it rises, the more afraid investors are. As you might imagine, it’s been falling since March while stocks rallied and confidence grew, and even continued to fall when the market was temporarily tripped up in May and July. Over the last two weeks though, the VIX has clearly changed direction - upward.

It’s not terribly evident on a daily chart, but when you take a look at the weekly chart (for the VIX as well as the broad market) it’s pretty clear something’s different. The VIX has handed us a rising MACD cross… the first in almost a year.

So how far is the market going to fall? That’s the good news. If it does indeed pull back, it doesn’t really need to retreat all that much to humble the bulls. All it really needs to do is slide back far enough to convince most investors the bull market is already over. Once the majority is convinced they need to be out of the market, I expect the bull trend to resume. That will also coincide with the norm of hitting lows in September, and then starting a major Q4 rally in October.

To be specific though, I think the S&P 500 will need to move all the way back to somewhere between 800 and 900. The lower level is about a 61.8% Fibonacci retracement, while the upper level is roughly a 38.2% Fibonacci retracement (sorry, neither is shown on the chart… not enough room). Hitting either level would mean quite a dip, but remember - the selloff has to be big enough to burn off all the euphoria before the bulls can reload.

As always, this analysis is not static but ongoing. Stay tuned.

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