The market took us for a real ride today.  We sent a note out to members well before the open when the Dow futures were down over 100 points on rumors of a pending Israeli attack on Iran.  While we didn’t get the high volume capitulation selloff we were hoping for today, this action is good enough.  Traders stepped in and bought the gap down right away, and we moved into positive territory by 11:00 (the better-than-expected ISM report certainly helped).  Then the market promptly reversed and made new intraday lows into lunch, before reversing again and rallying back up toward a positive close.

The SPX made what looks like a triple bottom today, and the hammer candlesticks in the Dow tell the same story: odds have improved somewhat for a substantial short-term bounce. Note that this would be at best a brief rally in the midst of a bear market: it would not be a place to initiate major new long positions, but rather an opportunity to exit any underperforming longs, protect profits from shorts, and look to sell call premium (ideally through verticals).

We’re not typically prone to predictions, but here’s one: we don’t see the indexes moving much higher this week, given the short day on Thursday and the long weekend.  We wouldn’t be surprised to see some positive action tomorrow morning followed by flat-to-negative trading the rest of the week.  Expect unremarkable volatility as well ahead of the long weekend.

Incidentally, what do we mean about selling premium?  Well, the change from buying naked options to selling options spreads makes all the difference in the world.  If you’re bullish right now, buying calls is about the worst thing you could do, since even if prices rise quickly, volatility will fall hard and eat up your gains.  So instead, you could sell a put vertical composed of one short OTM put and one long further OTM put in the same month.  This will bring in a credit (which is neither here nor there) but more importantly will profit from time decay, and will enable you to win even the market doesn’t rise very much or stays flat.

On a day like this, you really need to start off any post with some good news.  Apparently, one of the greatest television shows of our time might be made into a movie: we’re talking about Arrested Development.  So you see, there is hope for this country after all.  (Nevermind that we’re all so scared of the boogeyman that the government will be warrantlessly watching the movie over our shoulders; that’s a matter for another day.)

Okay, now to the issue at hand.  Markets gapped down at the open and never looked back, closing at the lows on higher volume.  Severe technical damage has been done to the indexes on a short and long term basis.  Key support levels from March 07, January 08, and March 08 should have held the selling in check, but the bears blew right through those lows.  This was a high volume, high intensity day in which no buyers ever really stepped up.  We kept hearing things throughout the day like, “Where are all the value investors?”  Off acting like Milford men, that’s where.

Before the open this morning, we sent a note to subscribers describing why we were still in full bearish mode:

Our opinion is still that we are in the midst of a bear market and that any rallies will be short-lived and indecisive.  Some market commentators (especially in the rah-rah corporate media) have been calling for another rally like the one we saw off the March lows.  The primary reason we reject this view is that the sectors that provided leadership during the March rally (tech, transports, energy) now appear overextended - or at least weakened - and we haven’t seen any new leaders emerge…

More importantly, we said that this was as good a time as any to tighten up those allocations and double-check your risk tolerance:

One other important point here is that this is a good time to double-check the allocations you’re working with.  This applies not just to our newsletter trades, but to your whole portfolio.  Revisit each open position, and ask yourself whether you would be comfortable if you ended up exiting that individual position for a 50% or even a 100% loss.  If the answer is no, then dial down your allocation.

Today was a perfect example of why we prefer to trade spreads on ETF options instead of the traditional big index products.  SPY quoted contracts a few pennies apart today, which is typical, while you could catch similar SPX strikes at a dollar and a half wide or more.  Good luck getting a fast and fair exit in the SPX pit on a day like today.

Where do we go from here?

The first thing to say is that action like this is not to be blown off - even if we bounce up 200 Dow points over the next couple trading days, that wouldn’t negate the horrible market internals and total lack of support we’re seeing now.  That said, here are some factors that may favor a snapback sooner rather than later:

• $SPXA50R - the percentage of S&P 500 stocks above their 50 day moving average has been a helpful tool in the past for discerning market tops and bottoms.  Over the past four years, on the five occasions when this indicator has been at 20 or below, the S&P 500 has been significantly higher in the weeks following.  Now that it is fashionable once again to disparage technical analysis, we’ll note that this particular indicator is actually quasi-fundamental: when too many high quality stocks are irrationally sold off, value-chasing buyers invariably step in to snap them up, and that tide lifts even the less seaworthy boats.  Click on the chart for a full view.
• RSI(14) - this is the old standby, the 14 period Relative Strength Index.  Going back to 1999, there are only about 15 occasions when the RSI(14) has fallen to 30 on the SPX daily chart.  When that happens, the index is almost invariably higher the following week(s).  One interesting, if unsettling caveat is the fact even a slow-moving indicator like this can get oversold and stay oversold through a pretty nasty fall, as happened twice in 2001 and once in 2002.  Even so, unless we’re in the middle of a slow motion market crash, the odds still seem to favor some moderation in the near future.
• $VIX - normally, this is the part where we comment on some beautiful VIX spike and how investor fear has gotten really overblown. But the story here is actually the relative complacency in implied volatility.  Not sure exactly what’s going on there, expect that in all likelihood the smart money has been putting on robust hedges for weeks now.  This is also a data point in favor of not using VIX options as a proxy for regular index price movement - there’s absolutely no guarantee of any 1:1 relationship.  But anyway, what do we make of the conventional wisdom that you can’t get a market bottom without a VIX spike?  Who knows?  (Well, our future selves of 3-4 weeks from now know, that’s who.)

One last thing.  If your portfolio got hammered today and you’re looking to rebalance, don’t kill all of the positive theta trades you have going by throwing in the towel and loading up on expensive puts.  If you want to get in on this trend, sell some OTM index call spreads; if you’re an uber-contrarian, sell some not-so-OTM put spreads.

The clamor over whether “speculators” are driving oil’s parabolic run-up has become almost deafening, with the number of Congressional hearings on the subject reaching 40 this week and the price of oil dominating the nightly news. For every market analyst making the case for a speculative frenzy, the media have found an industry expert to argue that high oil prices are justified by the underlying supply–demand imbalance and weak dollar. If this sounds familiar, it might be because the scenario looked quite similar when the housing bubble came to a head.

Way back in 2005 when the Philadelphia Housing Index peaked. . .no, make that 2006 when it took a major hit. . .er, wait,. . .2007 when it fell 50% from its January high—the National Association of Realtors and the National Association of Homebuilders still refused to admit that current home prices were unsustainable. The real estate bubble was due partly to low mortgage rates, partly to speculation, and mostly to buyers’ fear that if they didn’t buy now, they’d have to pay more later—but it took months of housing declines before the “experts” would admit that things weren’t exactly hunky-dory.

Yet the future was crystal-clear to anyone looking at the chart on the left. The Japanese stock market in the late 1980s (black line) defined modern bubblology, and the tech bubble (blue line) carved out a paragon of the hyperbolic spike. By the time real estate (green) had traced the same vertiginous ascent, the writing was on the wall.

Now the price chart for oil (red) is looking eerily familiar. Ignore the fact that oil appears to be peaking at the same level as its predecessors—each plot is scaled to the vertical dimension of the chart—but note the rate of ascent over the past year. That vertical wall is the scarlet ‘B’ that flashes “bubble” in ten-foot neon lights.

One of the most credible arguments against the speculation theory comes from Daniel Yergen, “one of the nation’s best-known energy experts,” according to the New York Times. A Times article yesterday focusing on Mr. Yergen’s expected testimony before Congress summarizes his position as follows:

As the ninth hearing of the month gets under way on Wednesday, . . .Daniel Yergin, is expected to tell Congress that the focus on speculation is largely misguided.

Mr. Yergin will join numerous other energy experts who have declared that the rise in oil prices can be explained by basic economic factors, such as the limited growth in supplies in recent years, a weakening dollar, a global surge in energy demand and a string of production disruptions in countries like Nigeria.

Buy wait—there’s more:

Mr. Yergin said the market is relentlessly bidding up oil prices in response to deep-seated fears that the growth in demand will keep outpacing the growth in oil supplies in coming years.

“There is a shortage psychology in the financial markets and that is reflected in the price of oil,” Mr. Yergin said in the interview. “You are seeing a lot of people who have never invested in commodities who are now piling into the market. But calling it speculation is way too simplistic.”

Notice that Yergin doesn’t just overlook the bubbly nature of current oil prices—he actually confirms it, with phrases like “deep-seated fears” and “shortage psychology in the financial markets.” And he doesn’t even touch on forces like the automotive manufacturers’ fixed-price gasoline offers, which must be pumping a huge amount of money (temporarily) into the futures market as these companies hedge their incentives.

But it’s two additional developments that put us over the top. For contrarians, there’s the premier of the cable-TV reality show Black Gold. And for the politically focused, there’s the Republicans’ no-holds-barred drive for legislation permitting oil drilling in previously prohibited off-shore locations, including the Arctic National Wildlife Refuge—heedless of the fact that it would take ten years to have any impact, and that this impact would be minuscule.

Granted, there’s no way to know when the oil bubble will burst. Also granted that the fundamentals do support a certain price that’s above where consumers would like it to be. And yes, the dollar’s weakness is reflected in the price of oil. Unlike the Nikkei, tech, and housing, however, this bubble is likely to deflate only partly, before resuming its climb until alternatives displace oil as our primary energy sources

Position in United States Oil Fund (USO).

We got a round of the correlation game started this afternoon, but it went nowhere fast: either headline writers are getting smarter, or today’s action is just too tenuous even for them! We realize we’ve never codified the rules of this game before, so:

1. Get your officemates or pals together, and visit the financial homepage of any mainstream media outlet. Y! Finance, Bloomberg, even CNN Money will do.
2. Scan the top headline.
3. If the headline makes a dubious assumption about causation, everyone take a drink (if you’re at the office with pals, shots of espresso or cans of Diet Coke or whatever will do).
4. Move to the next headline, and repeat.
5. The last person in their chair wins (if you’re playing the safe-for-work version, it’s the last person to run to the bathroom, I suppose).

Sometimes the staff writers get clever with the prepositions, substituting an “as” or a “while” for the standard “on” or “amid.” Common example: “Dow slips 200 points on inflation fears.” Today, we were met with the less glaringly absurd “Losses on Wall Street accelerate after crude prices reverse course and jump more than $2.50.” See, if the crude rally temporally preceded the market selloff, that sentence isn’t actually false, even if it still implies causation. Via the AP, Yahoo! Finance takes a broader, “everything but the kitchen sink” approach:

Dow Falls Below 12,000- AP
Stocks tumbled Wednesday amid renewed concerns about the financial sector and after FedEx Corp. warned that weakening demand and surging fuel costs would weigh on fiscal 2009 profits. The Dow Jones industrial average fell below the 12,000 mark for the first time since mid-March.

See, “concerns about the financial sector” can include everything from that dour RBS memo to the Fifth Third Bancorp mess, to the Morgan Stanley disappointment. Toss in the FedEx news, tag the oil meme, and your scattershot is guaranteed to hit the cause of today’s selling in there somewhere. Assuming there is a cause, that is. Nevermind that correlation is not causation.

P.S. The Associated Press has adopted a boneheaded policy regarding quotations and links by bloggers. To that end, we’re quoting their story but not linking to it. This is the kind of nonsense we’d expect from the RIAA or the MPAA. If the decision was rooted in the AP’s desire not to be made fun of by bloggers, we humbly suggest that a better solution would be for the AP to hire better (read: actual) investigative journalists.

Reversal Readings

Short term oversold readings are picking up here; the Dow in particular looks totally determined to channel its way down to a retest of the recent lows. We’re obviously plenty happy about the uptick in implied volatility, and will resume selling July premium shortly.

Remember, these are just some of the RSI(2) readings from the universe of ETFs we scan, no big deal.  Above 90 is overbought, under 10 is oversold; above 95 and under 5 might perhaps maybe be trade-worthy.  But as the man says, the market can remain irrational for longer than you can remain solvent.

DIA - 3.36
SPY - 4.87
QQQQ - 12.00
IWM - 14.10
XLE - Energy - 97.59
XLF - Financials - 7.34
XLV - Healthcare - 6.55 (seems like healthcare is perpetually on this list)
RTH - Retail - 4.90
GLD - Gold - 98.63
DBA - Agriculture - 98.01
EWW - Mexico - 1.44

For mental health reasons, we hardly ever watch CNBC anymore. But glancing at it this afternoon, at one point we saw three separate live graphics displaying the price of crude oil. So much screen space was taken up by live oil trackers, there wasn’t enough space left to show the chart of whatever alternative energy company they were pumping.

Was oil making a new high today? Did the U.S. unilaterally attack another country?  Did someone accidentally double-park in the Strait of Hormuz?  No.

If you feel like it’s been impossible to get away from oil and oil-related stories for too many years to count, that’s because you’re right. The CXO blog has a nice report up on a momentum-based sector investing strategy, and as they explain, the primary reason the strategy massively outperforms the S&P over the past decade is due to the energy sector.

Reversal Readings

Remember that the market can always digest oversold and overbought conditions by time rather than by price. Indexes gave up almost all of today’s gains, but still managed to close positive, relieving the oversold conditions from yesterday.

XLV - Healthcare - 0.30
XLB - Materials - 7.84
EWA - Australia - 0.38
IBB - Biotech - 6.72
DBC - Commodities - 94.84
XME - Metals & Mining - 4.91