The Nth Oversold Bounce As the Government Hunts for Shorts

By Dr. Duru written for One-Twenty

September 19, 2008

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Folks, we simply could not make this stuff up, even if we tried. As the government scrambles to pull off what should be the largest financial airlift in America's history, the S&P 500 gyrates wildly as it tags key technical support levels with uncanny precision. Yesterday, I noted how perfectly the S&P 500 bounced off the October, 2005 climactic lows. At that time I predicted/guessed: "The next support is around 1140 formed by a sharp correction in April, 2005. We are barely 1% above that level now and hitting that level will probably come with the VIX hitting 40 or greater." Sure enough, the very next day, the S&P 500 touched a low of 1133.50, and the VIX spiked to a high of 42, all on incredibly high volume. The VIX proceeded to slide rapidly from there and finished down on the day, 9 percentage points off the highs. We also saw the T2108, the percentage of stocks below their 40DMA, pop right back up above the magical 20% mark. (See TraderMike for charts of the day's action). The combination of extreme trading volume, a VIX spike to 6-year highs and then its rapid collapse, and an immediate rejection of the 20% level for the T2108 have all generated the kind of bottom we want to see to kick off our Nth oversold bounce and bear market rally. Stocks have been violently transferred from weak hands to the strong hands that are likely to put up a vigorous defense of these support levels.

VIX doubles in September

However, there is a pesky wildcard called the U.S. government....

Each intervention the government has tried has failed to eliminate the on-going chaos in the financial markets. We are moving from point A (peak of credit bubble) to point B (the wipe-out of all credit excess), and all the government can do is slow down the journey and make the adjustments as orderly as "governmentally" possible. The extraordinary complexity and scale of our problems has required the government to act in extraordinary ways. I believe I hear and read an increasing buzz that America is teetering on a kind of socialism for the (formerly?) rich. I am not quite ready to go there, but I do want to add my voice of disapproval of recent news that the SEC may be considering a temporary ban on all short-selling.

I understand the spirit of the SEC's efforts and applaud them. I read the SEC's recent emergency order regarding naked short-selling where it states: "We intend these enhanced delivery requirements and the anti-fraud rule to impose powerful disincentives to those who might otherwise exacerbate artificial price movements through “naked” short selling" because "The Commission continues to be concerned that there is a substantial threat of sudden and excessive fluctuations of securities prices and disruption in the functioning of the securities markets that could threaten fair and orderly markets." Naked short selling has been illegal for a while, and it is good the SEC is enforcing the law. But eliminating short-selling altogether could lead to unintended and unwanted consequences. For example, we could see INCREASES in volatility as liquidity dries up as market makers and other market players cannot properly hedge their risks, especially in the options market.

Such artificial price supports would represent a significant manipulation of the market. We investors and traders know that the market "always wins" (even if it is wrong). If current prices over-value companies, prices will eventually find a way to go down, no matter what artificial barriers are constructed, no matter how strong the delusions in a bubble. The government cannot legislate or regulate us into having confidence in questionable and flawed business models. Buyers do not have to buy into risky companies, and they do not have to fund them. On the other hand, if current prices under-value companies, eager buyers will eventually step in. If buyers are not strong enough to stem the tide of sellers, then it is likely that prices were allowed to get too high in the first place. Or maybe buyers have much better alternatives for investing their hard-earned dollars. Worst of all, the government has an increasing conflict of interest with respect to the stock market (and financial markets in general) as the Treasury and Federal Reserve take on direct stakes in the success of individual companies. (Perma-bear Bill Fleckenstein waxes poetic on his justified outrage on CNBC's Fast Money over this situation).

(Please make your opinions known to the SEC. You can find all the relevant email addresses by clicking here).

There has also been an effort to go after folks who spread false rumors of financial stress, presumably in support of short positions. I hope that the SEC also remembers to go after folks who spread false rumors that sucker people into over-paying for a stock.

Anyway, from what I am reading, it seems Thursday's incredible rally came as news of the potential SEC rule-change swept the market. If you were actively shorting the market at that time, clearly you were not paying attention to the signals indicating the market was getting deeply oversold...or you did not care. On the other hand, if the SEC backs down, we could still see an equally rapid reversal in prices, at least until we get more news about the next government rescue plan. In other words, the government itself is a major source of market volatility and uncertainty. The rules are subject to change at any time and are being made up as we go during these unprecedented times.

Enjoy this Nth oversold bounce while it lasts. Some final thoughts on what lies immediately ahead. Friday is an options expiration day. I think it's even one of those whopper quadruple whammies. There should be more violent moves as major players reposition portfolios. I suspect that many will allow their September put protection to expire without rolling over into October protection, especially given all the news about additional government supports to the market. This would mean you should expect more downward pressure next week if we even get a whiff of bad news. Do not forget that the end of this month marks the end of the quarter, and it is the end of the fiscal year for many funds. Look out for additional selling pressure on losing positions that makes the books more presentable - to the extent that is even possible. We should also see buying pressure on stocks that have been working recently - oddly enough, that might be homebuilders and retailers! Financials are a huge wildcard...

Be careful out there!

Full disclosure: Long S&P 500 in an index mutual fund (hedged). For other disclaimers click here.

© DR. DURU®, 2008