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When the Levee of Liquidity and Leverage Breaks


When the tide goes out market participants get to see who's been swimming without their shorts.


Cryin' won't help you, prayin' won't do you no good
When the levee breaks, mama, you got to move.

--When the Levee Breaks (Led Zeppelin)

Louis Winthrope III: Nenge? Nenge Mboko? It is me, Lionel Joseph!
Billy Ray Valentine: Lionel! From the African Education Conference!
Louis Winthrope III: Yah, mon, I was Director of Cultural Activities at the Haile Selassie Pavilion
Billy Ray Valentine: I remember the pavilion----we had big fun there!
Both: Boo-boo yah, boo-boo yah, boo-boo yah, hah! Boo-boo yah, boo-boo yah, boo-boo yah, hah!
Billy Ray Valentine: Oh, memories!
-Trading Places

Greed may be good, as Gordon Geko said. But, fear is great.

Whether it be fear of under performing which can generate jumping on the momentum bandwagon, the fear unleashed in a freefall, or fear of the unknown, fear without a doubt is the most powerful force in the market.

The air of seeming invincibility promulgated by a stock market that has shrugged off so many concerns for so long – not the least of which is the worst housing mess since the Great Depression according to Angelo Mozilo, the president of Countrywide Financial (CFC)– can prove fragile when time is up and the cycle of fear and greed turn.

We're seeing fear now, and fear can feed on itself. Last week the market had its worse week in five years.

Folks seem to forget that momentum is a double-edged sword. The same momentum that drove stocks up can drive them lower: months if not a year of gains can be wiped out in weeks. When the tide goes out market participants get to see who's been swimming without their shorts.

Market participants who were emboldened by the market's ability to shrug off the housing mess are reassessing that conviction: were the market's many home runs propelled by steroids? Was the market's muscle manufactured by a lake of liquidity and leverage? If so, watch out when the levee of that liquidity and leverage breaks.

The market decides in its inestimable wisdom when something matters. Of course, no one can tell us when the market decides that something matters – so just buy and hold. Of course, everyone knows the market can't be timed – or can it? Can cycles help decipher when the climb up the wall of worry finds Humpty Dumpty tipsy? Can cycles help determine when a decline down a waterslide of hope has dried up?

As I have been writing for a few months, the financial market's crowd psychology seems to be a cyclic phenomena of regularly recurring periodicity. In a Pivotal Set-up Worth Watching, I offered that the average time for a blow-off is 90 calendar days, which sometimes extends to four months. I went on to suggest that since the closing low this year occurred on March 5 and the intraday low occurred on March 14, which translates to an approximate window between June 5 and July 5 on the one hand and June 15 and July 15 on the other hand for the possibility of a climatic peak.

In what looks like a mirror image of last year's June/July double bottom, the S&P had a June/July top play out this year with a high on June 1st and another high on July 16th.

The notion of a mid-July high that I've been looking for also dovetails well with the analog of the 1990 and 1957 patterns mentioned in this space.

When the feet of the M-A pattern on the S&P were snapped on Thursday the index accelerated, scoring a 90% down day. Serving to underscore the significance of the turning point, a second 90% down day was registered on Friday - not just statistics for those long of stocks.

The sharp decline that I expected has begun. An important trendline was broken like a twig.

Click here to enlarge.

If I'm correct, the S&P will decline by 20–25% off its high between now and November. That doesn't mean it can't happen quickly.

Of course, this could all be just coincidence and a lucky guess on my part. However, right now it's an odds-on bet until proven otherwise. If I am wrong, the S&P should bottom no lower than the levels of the March low between 1364 to 1387 and then recapture 1490.

However, it's important to remember that the market seeks equilibrium. There is some interesting geometry arguing for a 20 to 25% decline.

  • Because the market has gone an inordinate period without as much as a 10% decline, I believe it is likely that if the sell signal is genuine then reversion to the mean argues for as much as a 20 to 25% decline.

  • I have mentioned the 17-year cycle, the Cicada Cycle, before which ties in with the July 1990 top, when the DJIA topped out at 2999.70. This is reminiscent of the recent record of the DJIA at precisely 14000.

  • It is interesting that we are in the time frame of the 240 month (20 year) anniversary of the 1987 peak on August 25 of that year. Why? Because 14,000 vibrates off the third week in August on the Square of Nine Chart. Additionally, as you recall the 2002 bear market levels of 768 S&P vibrates off early July. It is also notable that the prior all-time S&P high of 1553 vibrates off the date of August 25. The recent high on the S&P was 1555. The first week of July is also the anniversary of the major low in July 1932, 75 years ago. It is fascinating that the number 75 is precisely opposite July 16, the date of the recent S&P high. These are just some of the ways in which the Law of Vibration manifests through the lens of the Square of Nine Calculator.

  • Furthermore, I have mentioned the anniversary of the July 24 panic low. This current sell-off began on July 24. After that low in July 2002 the S&P exploded 24% in a month. Theoretically speaking, if the S&P carves out a mirror image fold-back and declines 25% off its high or 389 points it would take the S&P back to 1166.

  • I realize that the idea of 25% decline is unthinkable, but reversion to the means could ream out profits quickly if money managers start to panic about locking profits in before the end of the summer.

  • What's more, the geometry of this potentially crimson clockwork is compelling. Why? A weekly chart of the S&P shows a basically flat 2005 with a low in October of 2005 which started an impulsive advance from a low of – yes, 1168 S&P. Because markets seek equilibrium, should an accelerated decline occur, it is remarkable that 50% of the bull/bear range of 768 in 2002 to this July's 1555 S&P high is 787 points. 50% of that range is 393 points for a midpoint of, yes, 1162 S&P.

  • Markets may not move like a fine Swiss watch but markets do seek equilibrium. The first leg up in the bull from March 2003 covered one year and 374 points. This parallels the one year advance from the June/July workout low in 2006, while the 374 point range approximates a 393 point, 25% decline.

  • A move to 1165 would take the S&P back to square one. History shows that parabolic moves have a tendency to be magnetized back to their starting point –an Eiffel Tower, E ticket so to speak.

Is a sell-off to 1165 S&P unthinkable on the 20-year anniversary of 1987 and the hundredth anniversary of the credit crunch known as the Rich Man's Panic? Consider this: the range on the DJIA from its 1982 low of 777 to its 1987 high of 2722 was 1945 points. Half that range is 972.5 points for a mid-point of 1749.50 DJIA. The closing crash low in October 1987 was 1738.

Click here to enlarge.

Volatility is the market's métier. Equilibrium is the market's handmaiden. But, naturally timing in the market is everything, as it is in life.

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No positions in stocks mentioned.

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