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Jeff Saut Presents: Is a Selling Climax Likely??


The Jim Croce of finance?


"Stock prices have undergone considerable erosion in recent weeks, and many analysts contend that a selling climax is needed to clear the air before a meaningful recovery can develop.

A selling climax is, in a sense, a final emotional purge via a dramatic downward thrust. It is generally preceded by a persistent decline, with the weakness feeding upon itself and investors becoming more and more frustrated.

The most easily identifiable selling climax occurs in a single day, and is characterized by a particularly large drop in prices followed by an even sharper rebound (with a higher close than on the preceding day), all on exceptionally heavy volume. Here's how it happens:

Margin calls are already at a greatly increased level, and investors, caught up in the panic of the moment, choose to allow their stocks to be sold by their brokers at the market, rather than put up additional cash to secure their positions. Prices plummet in frenzied trading.

Then, suddenly, the fury of the selling subsides. Some traders decide to buy stocks to cover short positions and take their profits. All of the demand that arises initially meets little resistance, and prices advance easily. Soon volume picks up, and earlier losses are recouped in full.

Even such action may not represent the final turning point. Terminal phases of declining markets are not infrequently accompanied by a series of climaxes, with intervening rallies affording relief from margin-call pressure, which then builds up again if the price downtrend resumes.

Although recoveries are not necessarily more substantial in the months following a one-day reversal climax than in the period after either a series of climaxes or a rounding kind of bottom, there is greater confidence that the lows have been seen when the turn has been identified as the one-day type."

"The Outlook" - Standard and Poor's, 1990

A selling dry-up, or a selling-climax, has been the question we have pondered recently. And, last Tuesday we answered that question by issuing a Special Strategy Alert, one of only three such alerts we have published during the past four years. Since many of our readers failed to see said report, we thought we would reprise it again this morning. To wit:

"We don't pen many Special Strategy Alerts so when we do obviously we think something has changed. That something is the equity markets. Recall that for the past few weeks we have been suggesting that a trading bottom was at hand. Our only question was whether that bottom would be made by a selling-climax or a selling dry-up. Yesterday (10/24/05) that question was resolved in selling dry-up form. Verily, the DJIA had two opportunities to give us a selling-climax. The first was last week when Wednesday's Dow Delight (+128) was followed by Thursday's Dow Dump (-133). Yet on Friday the DJIA didn't really accelerate on the downside. The second potential selling-climax opportunity came yesterday on the Baghdad events and the bears still couldn't muster a selling-squall.

Plainly, the news from Iraq is getting worse and yesterday was no exception. Indeed, yesterday's events smacked very much of the Tet Offensive that began in 1968 and proved to be the turning point of the Vietnam War. Think about it. Iraqi insurgents crashed into the Red Zone (supposedly extremely secured by coalition forces) and managed to get to the allegedly 'secure' hotels that house most of the international media/contractors covering the war. Moreover, they were able to set off three huge car bombs. That, in our opinion, was why the administration prematurely announced the appointment of Ben Bernanke to the head of the Federal Reserve. And it worked, because Ben 'helicopter' Bernanke's nomination, when combined with Hurricane Wilma, left little room in the media for Baghdad.

Clearly, the stock market liked Mr. Bernanke's anointment, yet it should have come as no surprise given his elevation to the President's Council of Economic Advisors months ago. Also of no surprise should be the stock market's positive response since the DJIA rose 1.1% on the day of Paul Volcker's nomination and 1.7% on Alan Greenspan's. But memories are short on the street of dreams, for most new Fed Heads have come into that post in a hawkish mode to get the 'manhood' needed for the job. Recall Mr. Volcker came in as a 'hawk' and the equity markets went into a slow-motion crash. When Alan Greenspan was anointed (1987) the equity markets went into a real crash. Regrettably, Ben Bernanke will have to lose his 'helicopter' moniker and it is likely that he too will do that by coming into his position in a hawkish mode (read: continues to raise interest rates). And while that is the negative wildcard, our sense is that the equity market 'lows' have been made.

That 'bottoming' view is derived from our notes of 35 years and our sense of market history. As chronicled in our comments of the past two weeks, 'The history of October maulings is that they last three weeks and encompass roughly a 10% decline. They also tend to bottom near the end of the month with an 'I think I'm going to be sick' type of downside hour or two.' Obviously we have given up on the 'I think I'm going to be sick' selling-climax type of low. The reason is that time has run out for the downside and the action of the past few sessions has given the averages a 'cushion' above their recent reaction lows. Further, we are entering the months of November / December, which we have learned the hard way is a tough time of the year to put things away on the downside. This is likely because of the festive nature of the Thanksgiving, Christmas, and year-end ebullient seasonality. Even after the October 1929 crash 'they' could not break the markets back down in the November / December timeframe! Consequently, the 'call' is that the lows are 'in.' How far the rally will carry is anyone's guess since we never got the perfect crescendo downside climax. But, 'higher' is our call from here and we would therefore be buyers on any weakness."

Consistent with those thoughts, we continued to recommend scale-buying the indexes (DIA, NDX, BKX) for the trading side of the portfolio last week. Using the Dow Diamonds (DIA/$103.84) as an example, that scale-buying strategy should have you "long" somewhere between a half and two-thirds of a position with a cost basis of 102.6. As often noted in these missives, we like the scale-buying, and scale-selling, approach for ALL investment / trading positions.

The call for this week

Most of the major indices have rallied back to resistance levels. Consequently, an upside break-out would be of some significance, as well as in keeping with the strongest seasonality of the year (10/27 to 11/2). Yet we are not looking for any miracles because while the seasonality is right, and our short-term indicators are as oversold as they were at the March / April lows, a number of our intermediate-to longer-term indicators have broken down.

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