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We go to “Red Flag Flying” status this after last week’s sell off and the technical damage done to the major indexes and sectors.  We expect still lower prices ahead.  The markets remain overvalued and clearly investor sentiment has dramatically changed over the past few days.  As fast as this market has climbed, it’s perfectly plausible to imagine an unwind that could be just as fast and aggressive.

I would rather be “short” than in cash to seek profits in this environment, but the volatility and speed of this reversal has been quite breathtaking and so our cash position has been suitable for the times. 

I’m looking forward to more buying opportunities on the long side as this bottoming process and correction completes.  Short term, we’ll look for opportunities on the inverse side and in still strong sectors.  Our signals caught the start of the March rally very early on and we will watch for a “second chance” to participate in the next leg up when it comes.

In this week’s report we take a close look at what has happened and how the tide has changed and there are lots of charts to look at and so I hope it will make for interesting reading.

I’m writing this at just after 1:00 pm on Sunday in Oregon and CIT has just announced that they will be declaring bankruptcy within a few hours.   As we’ve discussed in this report, CIT is a major lender to small businesses and has been in trouble since the summer and this will be the fourth largest bankruptcy in U.S. history and generate a $2.3 Billion loss for the TARP program.

This news will very likely make for a volatile opening and trading day tomorrow.

Not that things haven’t been wild enough the last two weeks on Wall Street with the Dow Jones losing more than 100 points on 4 out of 6 days and putting in a +200 point gain on Thursday followed by a -250 point loss on Friday.  The widely followed VIX, the “greed and fear indicator,” surged last week and now is back to mid summer levels.

While still not at the nosebleed levels of early in the year, in the chart below we can see how a degree of panic returned to the market during the last days of October.

Chart courtesy of stockcharts.com

And major technical damage was done on the S&P 500, as well, with the index dropping below its 50 Day Moving Average and breaking through significant support at the 1040-1050 level.

Beyond that, the MACD continued a steeper descent as seen on the bottom panel of this chart.

 chart courtesy of www.stockcharts.com

I’m a student of Point and Figure Charting and many sectors and ETFs went to sell signals this week including major sectors like Oil and Gas Exploration (XOP) Homebuilders (XHB) Real Estate (IYR) Russell 2000 (IWM) and many of the formerly high flying emerging markets including Latin America, Brazil and Mexico.

But many major sectors remain on Point and Figure “buy” signals, including China, Financials, Industrials, Materials, Utilities, Consumer, Gold, Silver and Energy.

Among the major indexes, the Dow Jones went to a “sell” signal as did the NASDAQ and Russell 2000.  The Russell and NASDAQ also broke their October lows which were significant support and indicative of lower prices ahead.

On the S&P 500, 1020 is the magic number for the October lows which, if broken, could lead to a quick drop to 1000.

It should be noted, however, that the S&P remains on a buy signal, barely, after last week’s rout.  And all of the major indexes are still above their blue support lines and 200 Day Moving Averages and so still in technical long term up trends.

Further weakness is seen in that just 30% of all stocks are now above their 50 Day Moving Average, down from 90% just a month ago and Friday alone saw a shocking 42% decline in this percentage.  The 50 Day Moving Average is a widely followed indicator for short term strength and often used by technicians as a “sell” signal.

So what does it all mean?  Clearly a fast and sharp correction of 5% has taken place in just eight trading days beginning on October 20th.  Whether this is just a normal correction or becomes something more remains to be seen, of course, but in today’s world, moves that used to take years now take months and months have been compressed into days.

Just as clearly, the sentiment has changed rather abruptly as Thursday’s ‘better than expected” GDP report triggered a powerful rally but one that didn’t have any legs or follow through on Friday as consumer spending and sentiment remained weak.  Major technical support levels have been breached and so in my opinion, we can expect continued turbulence ahead as market participants try to figure out if this year’s euphoric rally has been justified or not.

Many economists put 890-1000 as fair price for the S&P 500, and we’ve been on a quick trip in that direction over the last few days.

 The View from 35,000 Feet

The only good news for the week was the 3.5% growth in GDP for the 3rd Quarter reported on Thursday.  The markets responded predictably but then reversed again on Friday as everyone wonders if the growth can be sustained without ongoing government support.

Treasury Secretary Geithner said as much on a Sunday talk show when he described his view of the recovery as being “uneven and choppy” and that “this is gonna be a different recovery from the past.  A lot of damage was caused by this crisis.  It’s just the beginning.  This is a very tough economy.”

No kidding, Tim.

Nine more banks failed on Friday, bringing the yearly total to 115, the highest count since 1992 and as we’ve discussed, this is going to continue for as far as the eye can see due to the strapped consumer, the devastated housing market, a precarious commercial real estate market and continued tight credit with the biggest banks reducing lending activity by double digit percentages.

But the biggest danger remains the consumer as spending in September dropped for the first time in five months.  As we’ve noted before, the consumer is 70% of the U.S. economy and all you need to do is understand what the consumer is doing to understand what the economy is and is going to do.  With continued weak employment, reduced hours and ongoing deleveraging, slow growth is certainly the most likely outcome.

 The Week Ahead

 It's going to be a huge week ahead for economic reports that will be market movers.

 Monday:  September Construction Spending, October ISM

Tuesday: September Factory Orders, October Auto Sales,

Wednesday: ADP Employment Report,

Thursday: Weekly Jobless Initial and Continuing Claims

Friday: October Non Farm Payrolls Report, October Unemployment Rate

Last night was the first Halloween in 20 years that I didn’t go trick or treating with at least one of my kids.  Our tradition was always to carve pumpkins and then go out together in seek of candy on the dark, autumn streets.

I would always wear the same costume they would, so over the years I’ve been Darth Vader, Phantom of the Opera, a ninja and a pirate among others.  But yesterday, my teenager was off with his friends and we couldn’t even find a pumpkin to carve as late afternoon settled over Bend.  As we drove home empty handed from the grocery store, my son said, “I’m sorry I grew up, Dad,” and I replied, “I’m sorry, too.”

But life does pass us all by and as he headed out the door dressed as “Edward” from the Twilight series and left the old man behind, I grabbed a single malt scotch and settled in to watch the Yankees game, remembering Halloweens past from his childhood and mine.

Wishing you a great weekend wherever you may be.               To get a Complimentary Special Report from Wall Street Sector Selector, click here:

 John

Wall Street Sector Selector

All information presented herein is for general information only and deemed to be from reliable sources, but we cannot guarantee its accuracy. Readers are strongly advised to check with their investment counselors before making any investment. There is risk of loss in all investment activity.