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In Current Market, Rallies Can't Be Trusted


Investor sentiment reaches panic-crash stage.


As fear stalked global equity markets over the past few days, volatility continued unabated and the CBOE Volatility Index (VIX) again scaled the panic levels of October 10th. The following chart tells the story:

Click to enlarge

For some perspective on the current stock market correction, Chart of the Day provides the graph below, illustrating all major stock market corrections (15% loss or greater) of the Dow Jones Industrial Index over the last 108 years.

Click to enlarge

Each dot on the chart represents a major correction as measured by the Dow. For example, the bear market that began in 1973 lasted 481 trading days and ended after the Dow declined by 45%.

According to the study:

"Since 1900, the Dow has undergone a major correction 26 times or one major correction every 4.2 years. As it stands right now, the current stock market correction (October 2007 peak to most recent low which occurred yesterday) would measure slightly below average in duration but above average in magnitude.

"In fact, of the 26 major stock market correction since 1900, the current stock market correction currently ranks as the fourth largest in magnitude (only the corrections beginning in 1906, 1929, and 1937 were greater) and is the most severe stock market correction of the post-World War II era."

Investor sentiment seems to be in panic-crash stage, and the market appears severely oversold with only 1.6% of the S&P 500 stocks trading above their 200-day moving averages. (The 200-day moving average is often viewed as a crude measure of the primary trend.)

It can't get much worse than this! But oversold conditions have so far not produced more than a temporary reprieve, and rallies (which are bound to happen from time to time) are therefore not to be trusted.

I am closely monitoring the surges in the US dollar and Japanese yen - low-yielding currencies previously used for funding risky investments - as a break of the uptrends in these two currencies will be a good indicator of the forced deleveraging selling starting to subside. Once this situation has played itself out, we should see a return to lower volatility levels and a return of confidence.

For a more lasting turnaround to happen, I would like to see more evidence of base formations, a 90% up-day, and relative outperformance by the financial sector.
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