THIS RALLY IS OVER - PART II: THE AFTERMATH

If you haven’t done so, you can read The Rally is Over and Here’s Why (Part I). Don’t even say that I didn’t warn you. The rally has been over a longtime ago. Let’s take a look at the technical picture of what happened today.

There was so much selling going on, but it was orderly and not panicky. If the selling was panicky, you would have seen a drop like this right near the open. However, Investors and traders continued to sell right before the close, dropping the indices to close at the low of the day. This is the largest one-day drop in the DJIA and S&P 500 this entire year, and there is great significant to that move which I will explain later on. Below is a sad day in the form of an Excel table:

American International Group (AIG) took down the entire DJIA today, dropping 60%, followed by Bank of America (BAC) dropping 21.3%, General Motors (GM) dropping 12%, and JP Morgan Chase (JPM) dropping 10%. The only component that was up was Coca-Cola (KO), a measly $0.25. The DJIA itself was down 4.4%.

The volume has been the greatest since 2005. A huge one-day drop accompanying this type of volume is a high priority, because after some hope of breaking the price-volume divergence trend, we have started it once again, on a much larger divergence that ever before. Notice how the DJIA formed a flag pattern. This is a continuation sign from the first one-day drop that broke the trend earlier this month. Also notice that the DJIA made six rally attempts at the 50-day MA – only to fail it all six times. Today’s drop foreshadows the inevitability of the start of a new primary leg down. This may potentially give the bear market another 4-6 months of continued living and breathing room. If you are unaware of the characteristics of a bear market, you can view my article on them. This was coming as you can see from the numerous warning signs.

The S&P 500 got smacked the hardest, dropping 4.7%. This is no surprise given that the S&P 500 is the most financial heavy index of all. Droppers include Lehman Brothers (LEH) down 94%, Washington Mutual (WM) down 26.7%, Wachovia (WB) down 25%, and several dozen smaller financial firms that got crushed today.

Again, notice how volume today completely engulfs the volume of any up day. One-day drops accompanying huge volume indicate a continuation of the downward trend. The most important thing to note about the S&P 500 is that the index broke its July low. I suspect that we have just started the third primary leg. What I fear for longs is that when a bear market exceeds two legs down, typically the third and following legs (until whenever the bear market it ends) are more violent and extremely volatile than the first two legs. This is due to the heightened emotional nature of investors still holding their positions at this point (“What do I do?!”, “Should I sell?!”). The market becomes erratic and irrational, and you must be prepared to deal with some major disturbances. If you thought today was bad, there’s a lot more of this coming. If the S&P 500 is unable to rally 300+ points within 1-3 days on volume as strong as today and follow with confirmation days with nearly as strong volume, then it’s over.

The most shielded index is the NASDAQ, due to the lack of financial components compared with the S&P 500. If someone has some kind of undeniable, insatiable urge to have to be long in this market, I suggest you stick with the components in the NASDAQ. One word of caution: a divergence between indices is bearish and the lagging index (the one that doesn’t fall as much as the others) usually falls the fastest towards the middle of the leg, so keep that in mind.

The positive for the NASDAQ is that it has tested its July low and is barely holding and has not failed it, yet. As you can see, there is major support near today’s close; however, this will mark the third test and the inability for the NASDAQ to rally to a new high (two rally attempts – both failed). Also notice that the index is forming lower highs, a bearish sign. Another positive is that today’s volume (on a down day) is keeping in-line with volume on up days, indicating that there wasn’t a major turnover. This means that people are still holding NASDAQ stocks despite the carnage. So if you have absolutely have to go long for some crazy reason, pick the best of breed in the NASDAQ.

The VIX is an indicator that serves its best purpose on days like today – to measure fear! Today marked the largest level since June and we have entered into an area where prior highs were achieved. Typically, when a high is achieved through 1) a bearish gap up, or 2) a doji, a reversal (up) occurred perfectly the next day. I expect to see one of these two patterns to form within 1-2 days. This isn’t a crystal ball, nor is it perfect, but the VIX shows you where we are and how scared people are. Up +23.5% today? People are scared!