Securities Research Services

Wednesday, June 13, 2007

Market Correction Probabilities Increase

There has been a lot of chatter this week about the similarities between the current market set up and the technical conditions that existed back in 1987 before the crash. Before we look at the similarities, we would point out that there are now measures of protection in place that should keep the market from suffering a similar fate. One reason the market crashed so hard in 1987 was due to the fact that the NASDAQ system was still in its developing stages and could not handle the order flow. Once the sell orders started to hit, they jammed up the system and panic ensued.

That said, similarities are eerie. The set up back in 1987 was a sharp market rally, followed by a steep pullback, that then recovered weakly only to make a nominal new high. Once the weak recovery played out, there was a huge air pocket below that did not lend support during the sell off.

Now take a look at the current NASDAQ chart. It to rallied sharply, suffered a hard correction, and has since moved up weakly only to make a nominal new high.

Note that this last leg higher where the nominal new high was achieved also occurred as money flow was negatively diverging against the uptrend. This indicates that smart money has been selling into the rally.

We have complained recently about how long positions have been stuck in the mud and that they have been prone to stop out failure due to the underlying distribution taking place. In fact, we have taken measures in recent weeks to close out all long positions and to start opening short positions as the market has stalled out.

Clearly the set up is the same now as it was in 1987. This does not mean that the market is doomed to suffer a similar crash. It is interesting to note though, we went back over the index charts over the years and every single time the market has set up like this, it has corrected. Most corrections just took more time to play out than the 1987 correction.

An important point to focus on: One last point to keep in mind, each one of these corrections led to an excellent buying opportunity. Most of which were followed by multi year runs higher. As such, we embrace the opportunities this set up seems to present.

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