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The Ex Ante Factor: Psycho Killer: Qu'est que c'est?

This update went out to TTC members on Oct 13th.

Friday, 10/19/2007, is the 20th anniversary of Black Monday when stock markets around the world crashed. We are all aware of the magnitude and severity of this fat tail market event as it has been well documented and debated. While a few of you may have been trading during that time, most of today's Wall Street traders were in diapers and likely have no concept of what it was like to be exposed to that type of meltdown. I used to discuss with my old boss at the CME who was clerking in the S&P pit at the time. He recalled, "no one knew where the market was, traders took their wads of order tickets threw them up in the air and walked out of the pit." In today's computer driven instant fill market it's hard to imagine what those traders or their customers must have experienced. I don't want to dwell on the causes, the chart patterns or economic conditions as this week many will try to draw parallels with today's market. There is a more viable lesson at work and one that confronts us on every executed trade.

Fear and Greed

As technicians, religiously analyzing charts, we sometimes neglect one of the most important components to market behavior that is psychology, sentiment or bias. Recognizing the prevailing crowd's psychology is paramount for contrarian traders seeking an edge. With so many investors caught wrong in the last market debacle, speculating on internet companies with a new paradigm to justify the mania there has been a proliferation of money dedicated to take advantage of the next "bubble". Public pensions and other large institutional money rotated into long/short strategies that were designed to shield from volatility and a market meltdown. Institutional demand for "hedge" funds has led to an unprecedented amount of money, much of it unsophisticated, speculating from the short side of the market. This short bias fad has spawned a new generation of perma-bears who will be damned (and fired) if they miss the next crash.

Lightening strikes and lottery tickets

The very nature of a 20 sigma event is that it is statistically impossible. So why do so many traders have standing bets on an event that in theory can't happen? Fat tail events such as Black Monday or the 2000 collapse of the tech bubble leave not only scars to P/L but also more enduring scars on psychology. No one likes to be made a fool and the legacy of these "crashes" is that of extreme bearish sentiment on those who think "we won't get fooled again" and "this time I will profit from the demise of others." Many of today's perma-bears who continue to short every rally as if it were a top were the same who bought the whole way down in 2001 looking for ever higher highs. These same traders finally puked at the lows and this time will likely be getting long at the top. Keep in mind, this sentiment is not just reserved for retail day traders. Recall that famed hedge fund manager Julian Robertson closed his Tiger fund in March 2000, after underperforming due to his resistance to buy into the tech boom. We shall see a similar, throwing in the towel from one of today's skeptics prior to a top.

Dominick often keeps us grounded by reminding us, "there is no top tick trophy" and "there will be no bears left when this market tops." Substantial capital has been preserved by following this advice over the past couple of years and as long as we keep this in mind we can stay ahead of the psychology of the crowd's behavior. Last week was a perfect example as the market was making new highs, Cramerica was piling into GOOG and Wall Street was raising price targets left and right. We were ignoring the hype and instead looking for a turn as Dominick identified a potential ending diagonal which would see an impulsive reversal lower. We got a false alarm on Wednesday which we soon covered but after hitting his maximum upside target at 1586.75 to the tick on Thursday afternoon the bottom fell out. This sharp late day reversal left pundits and analysts scratching their heads to determine the catalyst. We laughed at the ridiculous excuses, kept our focus and traded the charts in front of us which pointed to a potential reversal of trend. Friday's bounce was a typical retrace and if we start heading lower early next week we could be looking at a large swing.

If the pattern unfolds as we are expecting we should see prices heading lower next week. How it handles support could carry important implications to the pattern for the remainder of 2007. Bears will see us ending a large B wave off the August low with a violent C wave lower. Bulls will see us pulling back in a corrective 4th wave move prior to higher highs. Having removed our bias, we don't care which pattern unfolds as we are nimble and ready to pounce on either scenario. The initial downside target is in the 1520 range which is the near previous corrective move low. Finding support there could vault us to new highs while losing it could send us back near the lows of the year. The timing of this could coincide with the Fed's spooky 10/31 meeting.

Trick or treat?

The pundits and analysts attribute the rally on expectations of a Fed ease at the upcoming meeting. The bond market's recent flattening trend is not suggestive of another ease and we think the Fed will likely stand pat on Halloween. If general consensus is for an ease and we don't get one the market would be expected to sell off as the weak hands that piled in late want out of positions. However consider this, if the yield curve remains flat with a tight Fed policy stocks ironically could benefit from the lower long term interest rates. We think after flushing weak longs, the market could be setting the bears up for another squeeze to new highs where there is no apparent resistance which potentially could drive the capitulation necessary for a major turn.

Next week earnings season gets into full swing with the technology sector, among others, reporting results (GOOG reports Thursday). We also have October option expiration that has been preceded by heavy call buying and declining implied volatility premiums. With implied volatility near the lows (despite Thursday's spike) we think the market is susceptible to a wild week. With the DJIA up against the 1.382 from the 2002 low it's time to strap it on.

Bottom Line: The stock market is yet again near an important turning point. We have shifted from long exposure to net neutral or short and will adjust depending on how the market trades in the coming weeks. Thinking like a crook we must assume the market will not give bears an easy top to get short (they don't ring a bell) and in fact, we expect a capitulation prior to a major top.


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