We Will Fail Miserably or Capitulate Today – Watch SPY 85!

October 16, 2008
Author: Peter Stolcers, Founder of OneOption

Once the selling sets in, there's no stopping this freight train. The market was already pointing lower before yesterday's open and dismal economic data fueled the decline. A bigger than expected rise in core PPI and weak retail sales added to existing pessimism. This morning, a better than expected CPI and a small decrease in initial jobless claims helped to boost the market. Continuing jobless claims are still rising and they are above 3.7 million. After the open, industrial production was released and it fell 2.8% in September (the biggest decline in nearly 34 years). The hurricanes and the Boeing strike were to blame. This week we have already seen the largest one-day rally and the biggest one-day decline. The bears are in control and any rally is pounded once it loses its momentum. As I mentioned yesterday, I don't believe the capitulation rally will result from a specific news item. In the past, bailouts, rate cuts and stimulus packages have kept this market afloat. As soon as they materialize, the market tanks. All that matters is that credit markets stabilized and show signs of improvement. I believe we will start seeing results in the next few weeks. Banks have a new capital infusion and new loans will be guaranteed by the Fed for three years. This part of the bailout plan should help immediately. The market is impatient and it will shoot first and ask questions later. As the market has declined, brokerage firms have doubled or in some cases tripled margin requirements. Hedge funds use leverage and this action forces liquidation. They have been selling everything to generate cash and that unwinding process is continuing. In the next few weeks we are likely to learn that many hedge funds have failed. There are bargains and the market has more than factored in weak economic conditions. At this juncture it is pricing in additional liquidation and a slight chance for a financial collapse. As long as the credit crisis exists, valuation means nothing. Traders are forced to generate cash and they must sell at any price. Earnings have been decent and 52% of the companies have beat estimates while 32% have missed. After the close, Google and IBM will release results. Both companies have been strong performers and their stocks have been trashed. I believe there's a chance for each to rally on the news. The implied volatilities and market risk are high and I would not play either of them. We are approaching the VIX peak from last Friday and a failed retest would be positive (and expected since it represents an all-time high). Likewise, support at SPY 85 would also confirm a short-term bottom. How the market reacts at those two levels will determine their significance. If the market establishes a new low with ease, we are likely to keep heading lower. I would like to see us test that level this morning and reverse intraday. A follow-through rally tomorrow would confirm the support level. This is asking a lot from a weak market. If it materializes, start taking long positions. I am not trading the short side of the market at this stage. I am in cash, patiently waiting for signs of a capitulation low. The bullish snap back rally could be furious and I want to be ready. Option premiums are extremely high and a great way to approach this trade is to buy strong stocks. Place buy-stop orders above a short-term resistance level. When the capitulation low is in and the stocks explode higher, you will buy them as the orders are triggered. If the market keeps sinking, you will not get filled. I am seeing value everywhere, but the energy sector looks particularly attractive. One small disruption could fuel oil prices much higher. The market tried to rally early and now it is drifting lower. There is nothing to stop it and I expect SPY 85 to be tested today. We will either fail miserably or we will see a reversal. image

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