The market's in crisis mode... When the rubber band breaks... What you should do now... 'RB' is red...
Comparisons to 2008 abound... The Dow Jones tumbled 643.76 points yesterday – the sixth-biggest point fall in 112 years and the biggest drop since December 2008. The Dow dropped more than 500 points last Thursday. The S&P 500 is down 18% in the past two weeks. The market is crashing. And investors are terrified.
Gold – now viewed alongside Treasurys as the market's safe-haven asset – hit a record $1,782.50 an ounce overnight. The Volatility Index ("VIX") – the market's fear gauge – traded near 50 yesterday. (Twice as high as when we told you to watch the VIX two weeks ago.)
In addition to downgrading the U.S. Treasury debt, credit-ratings agencies are also downgrading corporate bonds, municipal bonds, and other government-related debt (like that of Fannie Mae and Freddie Mac). Financial stocks are cratering. (Bank of America fell more than 20% yesterday.)
The Federal Reserve will make an announcement today to (hopefully) calm the markets. Could the Fed already step in with another round of easing?
Mr. Market hates uncertainty... And right now he's befuddled.
Given the size and scope of the decline, we know many of our contrarian readers are ready to buy stocks... or even call options, which represent leveraged bets on rising stock prices. Rebounds from these oversold levels can be tremendous.
That's why we urge everyone to read Jeff Clark's latest take on the market, which he issued to readers of his S&A Short Report today. It's likely the most valuable piece of trading advice you'll see all week.
Please see an edited version of Jeff's advice below…
So much of trading involves recognizing extreme moves in the market – moves that have gone too far in one direction – and then betting on a reversion to the mean. It's that old rubber-band analogy. A rubber band can only stretch so far before it has to snap back the other way... or it breaks.
The stock market's rubber band broke last week.
Every technical indicator I follow shows extreme oversold conditions – conditions that should have led to a bounce already. Instead of bouncing, however, stocks fell further. The S&P 500 is down 14% in one week and 18% over the past two weeks. For all intents and purposes, the market crashed.
It wasn't as dramatic as it was in 1987. And it didn't happen in a matter of minutes like the "flash crash" last year. It was a persistent, two-week-long, water-torture-type of crash. But it was still a crash.
Crashes are emotional events. No amount of fundamental or technical analysis matters. Oversold conditions become even more oversold. Fear feeds on itself. And the selling continues.
Most of the time, it makes sense to buy into extreme oversold conditions. The odds favor the rubber band. Stocks usually do snap back. And the gains can be terrific.
But every once in a while, the rubber band breaks and the market collapses. That's what we're dealing with today. It's under this condition that we can appreciate the "limited loss" characteristic of options…
At first glance, buying call options to bet on a bounce in the overall stock market today also looks like a good move. Stocks are cheap relative to other assets. They are oversold (the understatement of the year). So a snap-back move higher is inevitable.
The problem, though, is the rubber band is broken.
When the rubber band breaks, volatility explodes and option prices skyrocket. Option buyers can't profit. Even if you're right on the direction of the trade, you won't make money... because the stock can't move enough to justify the cost of the option.
Also, when the rubber band breaks, the market doesn't behave in its usual fashion.
The first instinct for most traders is to buy into oversold conditions. This makes sense up to a point. After a crash, however... when the rubber band is broken... buying is suicidal. There's no telling how far the market can fall. And there's really no urgency to jump in, because the bottom of a crash is always retested. Let me explain...
There is no shortage of folks who claim to have bought stocks after the market crashed in 1987. I am not among them. I was a young pup with only five years in the business. While I was certain it was a good time to buy, I was scared to death to do so. The market had collapsed. I had just witnessed all benefits of fundamental and technical analysis dissolve before my eyes. I just couldn't pull the trigger.
That turned out to be a good thing. After the initial bounce off the lows, the market came back down and retested the bottom one month later. The same thing happened after the flash crash last year. We had a solid bounce followed by a retest of the lows just about one month later.
That seems to be the normal course of events following a market crash. Stocks fall to levels beyond what can be explained by traditional analysis. They put on a wicked bounce, which wipes out anyone who stayed short for too long and encourages those investors who tried to bottom fish in the midst of the decline. Then, stocks come back down and make a slightly lower low.
That is the ideal time to buy.
Take a look at this chart from 1987...
Stocks bounced about 15% in the days right after the 1987 crash. Six weeks later, they came back down and made a lower low.
Last year's flash crash was similar. The S&P 500 fell from 1,180 to 1,060 in a matter of minutes. Stocks bounced higher over the next few days and nearly regained all the lost ground. Six weeks later, the S&P made its final bottom around 1,020.
Here's how things look today...
The market has crashed. No one knows for sure where the bottom will be or when stocks will finally bounce. From a sentiment standpoint, we ought to be close.
Given the current extreme oversold conditions, a bounce higher could be huge. The S&P 500 could run all the way back up to 1,250 or so (the former support level on the chart) before running into resistance. That's a gain of about 12% from yesterday's closing price.
We could try to trade a bounce here. But call options are just too expensive. Option premiums are already factoring in a big move. Even if we nail the exact bottom of the market, stocks probably won't bounce enough to overcome the cost of the options.
Selling put options is a viable strategy. After all, if option premiums are too expensive to buy, selling them is usually a good idea. But remember... the market probably hasn't bottomed yet. If we go by previous "crash" episodes, any bounce will be short-lived. Stocks will drift back down and make a slightly lower low before establishing a final bottom. That will be the ideal time to sell put options.
So what should we do now?
Nothing.
There's no need to rush in and try to catch the bottom. The odds of doing that successfully are slim, and the prices you'd have to pay for the options are too expensive to create a good risk/reward setup…
As I said earlier, I think 1,250 is a reasonable target for any bounce in the S&P 500. That's enough of a move to crush anyone who held on to short trades too long and to get investors all excited about a year-end rally. We'll use that enthusiasm to establish a put option trade or two in anticipation of a decline back down to retest the lows of the current crash conditions.
It is during that retest that we'll have a chance to "catch the bottom" and load up on positions for a year-end rally.
But today, there is nothing for us to do.
Best regards and good trading,
Jeff Clark
Goldsmith comment: If you should trust anyone to help you navigate these tumultuous markets, it's Jeff Clark. He's traded crises before... And he usually produces huge returns. He thrives on volatility. To learn more about the S&A Short Report, click here...
New 52-week highs (as of 8/8/11): SPDR Gold Shares (GLD).
No matter how clearly we spell things out, some folks still miss it... Check today's mailbag for an example. And send your feedback to feedback@stansberryresearch.com.
"I too, don't take pen in hand but feel compelled. Seldom have I read a letter so clear and concise which addresses so many of life's core values such as personal and financial responsibility, to educate and freedom among others. J.H., I have taken the liberty to copy, laminate, and will read daily your words of wisdom. Thank you. Brilliant! WOW!!" – Paid-up subscriber Dennis A.
"Hey guys, Print my comments... I am red, big time following your advise and have been following you for years. The only thing that is showing green is Gold. Gold stocks over all are red. Resource stocks red. Financials red. The dividend payers are red. Would have been much better off, having money in the bank. Thanks guys! Wasted time, effort and money." – Paid-up subscriber RB
Goldsmith comment: Maybe you misread some of our advice over the years, RB. Just in case, I've reprinted a few warnings to be cautious below…
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In [the December 2008 issue], we told folks to "buy as much gold bullion as you can reasonably afford." We're repeating these warnings again today because the market for U.S. Treasurys recently "broke down" through an important level. – Stansberry's Investment Advisory, February 2011 |
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Putting these market-based signs together with what we know about the fundamentals of the world's major economies – half of which appear bankrupt – I'm quite happy to be in the "batten down the hatches" camp. Investors who are merely able to keep what they've earned (in real terms, after inflation) over the next several years will have done a great job. |
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My best advice has been the same since February 2010. If you're not willing to hedge your portfolio by shorting stocks and holding plenty of physical bullion (gold and silver), you should allocate 50% to short-term Treasury bills (or the exchange-traded fund SHY, if you don't buy them directly) and 50% to gold (GLD, if you don't buy it directly). – Stansberry's Investment Advisory, July 2011 |
Regards,
Sean Goldsmith
Baltimore, Maryland
August 9, 2011